Portfolio Diversification Strategy Importance Meaning Definition

Deal with Market Volatility with Portfolio Diversification

Volatility as a term is not really new to us. However, for the uninitiated, volatility simply refers to sharp movements or changes that cause uncertainty in future outcomes. If you are staying in the financial capital then you would surely have encountered the volatility in Mumbai rains. During monsoons it often happens that the sun is bright and shiny when you leave the house in the morning, but suddenly it starts pouring as you weave through the city’s infamous traffic. Or, if you are in the northern regions, particularly in Delhi, you would be able to talk for hours about the volatile winters. While one day would be bone-chillingly cold, the next day could very well see you sweltering in your winter wear. However, we find fixes for these volatilities. In Mumbai, you would not leave the house without an umbrella and, in Delhi, you would always have a sweater handy, in case the temperature drops. Market volatility is much the same – you can never predict it, but you can surely prepare for it.

The stock markets are similar in nature. They are inherently volatile and persistently witness ups and downs. While all investors may have heard of volatility, not all are prepared to face it. Market volatility compels us to make bad investment decisions as it invokes the double edged sword of greed and fear. The fear of making losses and the greed to make more profits often influences you and compels you to make sub-optimal investment decisions. However, as they say, a fool and his money are soon parted, so, avoid being foolish and ensure that you deal with market volatility through portfolio diversification.

What is portfolio diversification?

Portfolio diversification is the practice of investing your money across a variety of asset classes and securities such that any sharp and negative movements in any one asset class or investments do not have a large impact on your overall portfolio. Generally, different asset classes have zero to negative correlation with each other. This means that while a certain news flow could have a negative impact on one asset class it could either have no impact or even a positive impact on another asset class. For example, the impact of rising interest rates on equity prices and bond prices could significantly differ. So, if you have a mix of bond and equity investments in your portfolio then the negative impact of rising interest rates on one asset class could be offset by the positive or negligible impact on the other asset class. However, portfolio diversification is not just limited to asset class diversification. If you want to deal with market volatility, then you must diversify within your equity portfolio as well. This means investing across market capitalisations, themes, and sectors.

Optimal portfolio diversification

If you really want to deal with market volatility with portfolio diversification then you must ensure that the way you diversify your portfolio adheres to your asset allocation strategy. The investments that you make across multiple asset classes and within a single asset class should be such that they adhere to your overall risk constraints and are able to deliver the desired returns. An essential part of dealing with market volatility is discipline. Thus, you must be disciplined in your portfolio diversification and ensure that all investments are aligned with your overall asset allocation.

Portfolio management is considered an art in today’s highly volatile market scenario and if you are able to let go of your biases and ensure portfolio diversification, in line with other factors such as your age, financial goals, risk profile, and return expectations, your corpus will remain comparatively safe even during worrisome market volatility and downturns. While investing all your money in one strong asset may seem intuitive at the start of your journey, it is, actually, a faulty move and, at the end of the investing day, it is portfolio diversification which will keep your corpus secure and sound.