Creating an Optimal Portfolio Diversification Strategy

Prem and Ratan are good friends. They are of the same age, have grown up together, and also started their earnings journey together. They take advice from each other in nearly every aspect of their lives. So, when Ratan told Prem about the importance of portfolio diversification, he listened.

The first question that came to his mind was, ‘what is portfolio diversification’?

Ratan explained to him that portfolio diversification is an investment strategy that entails investing in different asset classes including debt, equity, commodities, etc., and also investing across different themes, sectors, and market capitalisations within each asset class.

The next question that came to Prem’s mind was, ‘why is portfolio diversification important’?

Ratan started his explanation with a simple analogy. He said, ‘Prem, have you ever heard of the adage, don’t put all your eggs in one basket?’ Well, investing is similar in nature. You don’t put all your investments in the same asset class’. Delving deeper, he explained that every asset class and even investment has a specific risk and return potential. At the same time, different asset classes respond differently to the same set of events or developments. When you diversify your portfolio across multiple asset classes, you ensure that sharp, negative movements in any one asset class do not have an inordinately large impact on your portfolio. By doing this, you are able to reduce the overall risk of your portfolio.

Prem was immediately able to appreciate the importance of portfolio diversification. Now, all he wanted to know was how he could achieve optimal portfolio diversification. To this Ratan replied that Prem could simply diversify his investment portfolio the same way that he had. So, Prem went about copying Ratan’s portfolio diversification strategy and invested 70% in equities, 25% in debt, and 5% in gold. Unfortunately for Prem, this was not great advice.

Even though both Prem and Ratan are of the same age, there are stark differences in their income levels and lifestyle. Ratan is single, has no loans, and is earning Rs. 1,00,000 per month. Prem recently got married, has an education loan to pay off, and is currently earning Rs. 85,000 per month. The amount of risk that Prem can potentially take is far lower than the risk that Ratan can take. Accordingly, a 70% allocation to equities is very high for someone like Prem. What Prem should ideally do is consult a financial advisor and assess his risk profile and return objectives. Once that is determined, then based on his unique risk profile and return objectives, he should create a portfolio diversification strategy. The key to making portfolio diversification work is to create a personalised portfolio diversification plan. The three main things that you need to focus on to achieve that include:

Your risk profile: This takes into consideration your willingness and ability to take risks. While your ability to take risk can be measured by assessing your current income and liabilities, your willingness to take risk cannot be easily measured. However, you can take a few psychometric tests to understand your comfort with taking risks. Together, these two will determine your risk profile.

Your return requirements: At the end of the day, the reason you save and invest is to generate sufficient returns to meet your financial goals. If you take too little risk and generate minimal returns, then you will not be able to achieve your financial goals, thereby defeating the very purpose of investing. Thus, take a step back and understand why you are investing, how much money you need to achieve each individual goal, how much money you can invest, and therefore, what are your return requirements.

Your investment time horizon: This indicates the time period for which you can stay invested and also has an impact on the level of risk that you can take. If your investment time horizon is short-term in nature, then you will be able to take very little to no risk. This means that equities might not be a viable option for you. On the other hand, if your time horizon is long-term in nature, i.e., greater than 5 years, then you might be able to take higher risk and invest in equities.

When creating a portfolio diversification strategy, you must focus on what works best for you. This is the reason why an optimal portfolio diversification strategy should be personalised and should be aligned with your unique risk-return requirements.

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