We, human beings, love having options and varieties. Be it clothes, food, investments, and many other things. This way, even if we run out of one or two options, we had other opportunities to grab onto. In essence, this is what diversification is all about.
Portfolio Diversification is one of the ways to balance out the risk and reward in the investment portfolio by diversifying the assets. This practice is designed to help reduce the volatility of the portfolio over time.
But just imagine, what would have happened, if all the money was invested in a single security. Everything would have been dependent upon just one security's performance. And in case the market goes south, then the entire investment could blow away in one go.
Purpose of Portfolio Diversification
The purpose of portfolio diversification is to balance out the risk and reward in the investments, specifically unprecedented and unsystematic risks.
Unsystematic risk is related to a specific company or market segment. Unprecedented risk is related to turn of events and its effects which are known to no one, for example, Covid-19, Ukraine-Russia Crisis, many other such events.
By diversifying the portfolio, these risks can be avoided to an extent. In this manner, all the investments would not be affected in the same way by the market events.
Ways to diversify portfolio
- Pool of Investments - Investing in equity markets is good but that doesn't mean that one should invest the entire wealth in just one or two stocks. This is where diversification comes into picture. Investing in more than one or two stocks is a good way to manage the risk and reward in the near future. Even while diversifying the portfolio and investing in more stocks, it is critical to analyse the fundamentals of a company, the investment amount in a particular stock and the time period for which the amount would be invested in a particular stock.
- Explore other investment options - Mutual funds, bonds, real estate, and pension plans are the other investment plans one can consider, other than investing in the equity markets. By investing in bond and equity markets, one can balance out any negative results in one market by positive trends in the other. This way, one can ensure that they are not in a lose-lose solution.
- Index and Bond Funds - Index and bond funds are considered to be fixed-income solutions. So by adding some fixed-income solutions to the portfolio, one can further hedge their portfolio against market volatility and uncertainty. Investing in index and bond funds is highly cost-effective as the charges are quite low compared to other forms of investments.
- Spreading the portfolio - Another portfolio diversification strategy is to spread the portfolio into various asset classes, equities, debt and fixed return investments. Adopting new ways of investing can help in maintaining the risk and managing the volatility in the markets.
- Exit Time - While investing and diversifying the portfolio, it is also critical to map the exit time from the market and manage the portfolio from incurring any losses. Walking with the market trends and being updated of the happenings in the market is an essential requirement of knowing when to get out of the market.
Conclusion
Diversification doesn't mean that an individual doesn't face any losses. It means that an individual is fundamentally content with the market and is aware of the trends while diversifying the portfolio and knows when to exit the market in order to avoid the major losses while managing the balance between risk and reward. Get research-based trade recommendations and be a responsible trader.
Happy Investing!
