As the proverb goes, ‘never put all your eggs in one basket’.
Diversification is the technique of spreading your investments across different types of assets, such as stocks, bonds, or real estate, so that the performance of any one investment will not have a disproportionate impact on your overall portfolio. Diversification is a crucial principle of investing that can help reduce risk in your portfolio. But the thing to recognize is that reduced risk also reduces your return potential.
Diversification using Equity and Fixed Income Assets
One way to diversify your portfolio is to invest in a mix of equity and fixed-income assets. Equity investments, such as stocks, can provide the potential for higher returns, but they also carry a higher level of risk. On the other hand, fixed-income assets, such as bonds, provide a more stable source of returns, but they generally have lower returns. Therefore, including both types of assets in your portfolio can balance the potential for higher returns with a more stable source of returns.
Diversification using Domestic and International Assets
Another way to diversify your portfolio is to invest in both domestic and international assets. Investing in both domestic and international assets can help spread risk across different economies and currencies, which can provide a buffer against economic downturns or currency fluctuations in any one country. Furthermore, investing in foreign countries can also expose your portfolio to different stages of business cycles to benefit from the growth of economies that are doing better.
Diversification using Different Time Horizons
In addition to investing in different types of assets across other markets, you can diversify your portfolio by investing in different time horizons. For example, you can invest in short-term investments, such as money market funds, for liquidity and stability while also investing in long-term assets, such as equities, for growth and potentially higher returns.
Diversification using Asset Sub-categories
In addition to investing in different types of assets across markets and time horizons, you can diversify your investments in each class by investing in various sub-categories. For example, you can diversify your share investment by spreading it across large cap, medium cap, small cap, etc., and reduce the volatility caused by temporary dips in one category.
Understanding the Correlation between assets
Diversification is about spreading your investments across different asset classes and understanding the relationship between the additional assets. Just because an investment is in a separate asset class doesn’t necessarily mean it is diversified if the assets are highly correlated. For example, investing in multiple emerging market stocks could lead to higher risk than investing in a mix of emerging market stocks and bonds.
In summary, diversification is a powerful tool that you can use to manage risk and stability of your overall return on investment. By spreading your investments across different types of assets, sectors, markets, and time horizons, you can reduce any temporarily poor-performing investment’s impact on your overall portfolio and provide the opportunity for higher returns over the long term. However, diversification will not be helpful if the investment is a bad asset.
One of the fundamental steps in good investing is to track and review your portfolio regularly and make adjustments as and when required. And the same applies to diversification, and one needs to assess and maintain the right balance of diversification constantly.