The ancient saying “don’t put all your eggs in one basket” is all the more relevant in the case of finance and investing. Every investor wants to minimise their risk, but most people make mistakes while diversifying. Thus, it goes without saying that portfolio diversification is a vital part of making the most of one’s investments.
What is Portfolio Diversification?
Portfolio diversification is a method of risk management where investors divide their capital between various financial securities. By segregating their money into different investments like stocks, bonds, mutual funds, precious metals and derivatives, the investor can minimise risk and maximise potential output.
While portfolio diversification does not eradicate risk, it is an all-important step towards achieving financial objectives. Diversification is achieved by spreading the capital across different asset classes, industries or business segments. That ensures that even if one investment fails, others are there to make up for it and maximise returns.
Portfolio Diversification Tips
Portfolio diversification is often easier said than done. While most investors understand the concept, many can’t do it properly. Here are a few tips for you to ace your portfolio diversification strategy.
Spread out your investments
As we mentioned earlier, not putting all eggs in one basket is the key. Smart investors never put their money in only one kind of investment. Try to invest in multiple securities like stocks, mutual funds and even digital gold. It will keep your capital secure and will also yield better returns.
Research before investing
Never go into an investment without being fully aware of all details. Conduct proper research about the investment, potential risks, and the risk-reward equation. Fully understanding the investments will help you make the most out of the investment opportunities that come your way.
Match risk appetite with financial objectives
Different types of investors will diversify in different ways. Therefore, it is necessary to match one’s risk appetite with their financial goals and diversify accordingly.
Keep updating your portfolio regularly
The markets are always changing, and your portfolio should be no different. It is advisable to update your portfolio from time to time and make meaningful changes in the invested amount, asset classes and risk exposure. Making frequent changes to your portfolio will help tackle the unexpected happenings in the securities market
Invest in tax-saving schemes
What is the point of maximising the returns of your portfolio if you end up paying hefty taxes on your gains? Therefore, investing in tax-saving schemes is a vital facet of portfolio diversification. Investing in tax-saving insurance schemes not only reduces tax liability but also secures you against unexpected emergencies.
Set a target and know when to exit
Investors often succumb to their emotions and lose money on their investments. Portfolio diversification also includes setting realistic targets for your investments and having a well-planned exit strategy in place. Don’t give in to emotions like greed or unrealistic optimism and operate using quantifiable objectives.
Understanding the Pros and Cons
Like everything else, portfolio diversification also has its advantages and disadvantages.
Advantages of diversification
Shock-proofing your portfolio
Diversifying your portfolio properly will help you brave all market ups and downs. If the capital invested and the subsequent risk is spread across different assets, all assets make up for each other’s shortcomings. It ensures that your portfolio is well protected against all scenarios.
Weather market cycles
We know that economies go through a business cycle. The securities markets move in a similar manner, and a well-diversified portfolio ensures that your investment can go through all ups and downs with relative ease.
Added financial stability and peace of mind
Investing money is never easy. What if you lose your money? What if the markets crash? These are all valid questions, and portfolio diversification ensures that such apprehensions never arise in your mind. Proper diversification makes the portfolio stable and provides peace of mind to the investors.
Disadvantages of Portfolio Diversification
Complicated taxes
By investing in various asset classes, an investor exposes themself to different tax structures. Because every security is taxed differently, a diversified portfolio often gives birth to tax complications.
Risk of investing in unknown assets
Beginners often invest their money in unknown assets in the name of diversification. More often than not, they regret that decision. Therefore, one must be extremely careful while diversifying their portfolio.
Missed opportunities
Imagine that you invested only five percent of your capital in Maruti Suzuki, and the company announces all-time high profits. The share prices will immediately surge and you will regret not investing more money in the company. This is a big drawback of diversification that investors are often unable to make the most out of a potential investment.
Bottom Line
Ask any veteran investor, and they will all tell you that risk can never be zero. However, portfolio diversification ensures that risk is as close to zero as possible. It enables investors to minimise risks while at the same time maximising the potential returns. Now that you know how important portfolio diversification is, it is clear why it is the next thing you should focus on!
