You might have read innumerable financial experts discussing the importance of investment diversification. But what does it actually mean? And how exactly can investors implement this strategy to reap rich dividends and meet their financial goals in time? Do different group of investors need to have a different approach while exercising investment diversification? Read on as we discuss a few tips you’ll find very useful.
To begin with, diversification of investments refers to investing in a mix of asset classes, each with different risk and reward characteristics to reduce the overall risk associated with the investment portfolio. The purpose of investment diversification is to mitigate risk according to the investor’s profile.
Diversification reduces risks in investments by investing money in multiple asset classes. Let’s understand this with the help of a simple example. If I invest only in equity instruments, I face the risk of capital erosion if the market falls. However, if I invest a part in equities and another part in gold, the risk will be reduced. Because, when stock markets are doing badly, the price of gold is normally seen rising. So, I can counterbalance the loss, and the overall risk will get reduced.
Diversifying Within The Same Asset Class
You can diversify your investments even if you don’t want to add other asset classes to your investment portfolio. Let’s suppose you want to invest the entire corpus only in equity instruments. Under equity investments, small or mid-cap stocks usually give maximum returns, but the risk attached to them is also very high. At the same time, blue-chip or large-cap stocks provide a comparatively stable return and are less risky options too.
So, a risk-mitigating strategy could be to diversify investments in both types of stocks. An equity investor may want to invest 70% in large-cap/blue-chips and 30% in small/mid-cap stocks. However, the ratio of investment allocation in small, medium or large-cap stocks may vary depending on the risk appetite of the investor and the return expectations mandated by their financial goals.
Diversifying Across Different Asset Classes
Now, let’s look at another case. Equity investments carry risks, because of which many investors are wary of putting their entire money in it. And rightly so. But, at the same time, they do not want to miss the opportunity of high returns that the equity class provides. Perhaps a prudent strategy to earn high returns while remaining safe would be to invest a portion in equities and another in debt.
Now, the question arises: do most investors have enough knowledge or adequate time to study and select the right products for diversification? The answer would be mostly ‘no’. For such investors, it is rather better to rely on mutual funds. Mutual funds offer great diversification opportunities across different asset classes and within the same asset class too. Read on for more.
Diversification Through Mutual Funds
If an investor wants to put money only in the equity class, there are a plethora of choices available under mutual funds. Equity mutual funds offer a variety of funds for investors of all hues. There are mutual funds that focus on large-caps and small/mid-caps, while there are sector-specific funds too. There are various mutual fund schemes available in the market that focus on gold, debt, real estate, commodities, etc. An investor can divide the investment into different schemes to minimise the risk and get an adequate return as per his/her financial goals.
On the other hand, if an investor is not comfortable with all equity investments, he/she can also look for investing in debt funds or balanced funds. Balanced funds invest a part of the corpus in debts (government bonds, corporate bonds, fixed deposits, etc.) and a part in equities. This provides investors with the advantage of high returns through exposure in equity and capital protection through exposure in debt. The investor can also customise the diversification by investing a part of the corpus in equity funds and the remaining in balanced or debt funds.
There is another type of fund called dynamic funds. These change their proportion of equity and debt based on the market situation. By investing in dynamic funds, an investor need not need to worry about the market level or the volatility as appropriate decisions are taken by the fund managers.
For example, if the market is at the peak and the scope of stock market growth is limited, the fund will reduce its equity exposure and increase its debt exposure. And if the market is down and there is ample scope for growth, the portion of equity will go up while that of debt will come down.
Diversification For Different Types Of Investors
Investors in various age groups may require a different level of diversification. One diversification plan may not suit all investors, and it needs to be customised as per their age, risk appetite, and return expectation.
Investors in their 20s & 30s: Young investors have a longer investment horizon and bigger risk appetite. Hence, they can put their maximum investment in equities and a small portion in debt. The ratio could be 70% in equity and 30% in debt. One often-quoted thumb-rule is that the percentage of debt investments in your portfolio should be equal to your age, and the rest should be equity. So, for example, if you’re 30, then 70% of your portfolio should be equity and 30% should be debt.
Retired investors: Investors who have retired from an active job cannot take many risks. For them, the preservation of capital is more important. Hence, they should invest a significant amount, 70% – 90% of the corpus, in debt funds/instruments or bank fixed deposits. This will ensure that they do not lose money because of market fluctuations.
Always remember that the ultimate purpose of investment diversification is to reduce risk. Risk and returns are connected, and they are directly proportional. Any reduction in risk will also reduce the potential return. Investors must understand this and try to strike the perfect balance. They should not hesitate to consult with an investment advisor if they find it tricky to proceed.
Also, they should avoid over-diversifying their investments to keep the risk factor under control. Investing in far too many instruments can be self-defeating and might not produce intended results. Firstly, because it might get really difficult to track and manage so many different varieties of investments. And secondly, the over-all risk-managing benefit of investments could be insufficient to meet the investor’s financial goals in time. As such, investors should look to secure optimal diversification and stick to an intelligent spread of meaningful instruments that they’re comfortable investing in to achieve their financial targets.
The author is CEO, BankBazaar.com