Why portfolio diversification is important
Bollywood movies can often be quite an inspiration and teach us important lessons, for life as well as for investing. For example, think of the movie Chak De. It taught us about the sport hockey, about the importance of teamwork, and also the significance of a good coach. However, it also teaches us something important about investing.
Take a step back and think about the game of hockey. There are 11 players in each team. Now, you could build a team of the 11 best attackers in the world and yet lose a match. Why do you think that would happen? Simply because the attackers have only one talent, i.e., to shoot a goal. You need other players like defenders, flankers, and a goal-keeper to help you win matches. It needs to be a mix of the best rather than the best in only one skill. Your investment portfolio is similar in nature.
Assume that you want to benefit from the growth potential of equities and create an investment portfolio comprising primarily equity instruments like direct equities, equity stoxbox, and equity mutual funds. Now, as long as the stock market is going up, your all-equity portfolio will continue to do very well. However, what happens when the markets fall? The value of your entire investment portfolio falls. There is nothing to cushion the fall.
On the other hand, assume that you are highly risk averse and thus create an investment portfolio comprising only fixed-income securities like fixed-deposits and very low-risk debt mutual funds? You will not be able to participate in equity market rallies and grow the value of your investment portfolio. Further, you might not even generate sufficient returns to beat inflation. This way, instead of witnessing growth, the value of your investment portfolio might just erode.
The same applies to several other asset classes as well since each asset class has a certain risk profile and adds a certain advantage to your investment portfolio. So, the best way forward would be to focus on portfolio diversification. This means creating a diversified investment portfolio that has a mix of different asset classes in a proportion that will help you meet your portfolio goals while adhering to your risk boundaries. Before we move on to how you can create an optimally diversified portfolio, lets first understand what is portfolio diversification?
Portfolio diversification entails spreading your portfolio investments across multiple asset classes such that sharp movements in any one asset class do not have a large impact on the overall risk or returns of your investment portfolio. Simply put, portfolio diversification can help you enhance the risk adjusted returns of your portfolio. Now that we are clear on what is portfolio diversification, let’s see how you can achieve optimal portfolio diversification.
Just like in the game of hockey, gold investments can act like goalkeepers that hedge your portfolio during periods of economic uncertainty and equity market volatility, a mix of debt mutual funds, a large-cap stoxbox, and an Index Exchange Traded Funds (ETFs) are like defenders that can potentially offer consistent and stable returns, attackers can be thematic and multi-cap stoxbox that can potentially generate good long-term returns, and flankers can be special funds like international equity funds. When you create a diversified portfolio, you can reap the benefits of every type of investment, thereby giving your portfolio a definite edge.
Equally important is the risk mitigation benefit of diversification which makes portfolio diversification very important. Generally, the response of each asset class to the same set of news flows and developments can be different. This means that while a certain development may cause one asset class to fall, another asset class could remain stable and maybe even rise in response. Thus, by creating a diversified investment portfolio you ensure that sharp negative movements in any one asset do not have a large impact on your portfolio.
The bottom line is that diversification can help you benefit from investment in various asset classes and reduce the downside risk of your portfolio, thereby enhancing the overall risk-adjusted returns of your portfolio.
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