How to diversify your portfolio like an expert?

TomorrowMakers ™

How to diversify your portfolio like an expert?

30 June 2017
Confused about managing your investment portfolio? Here are a few things you can follow to diversify them

Shanti, a 30-year-old retailer, has been investing her money for the past six months, and has learnt a few investment strategies that could help her increase her profits. For example, she knows that diversification helps reduce risks and increase returns. But she does not yet know that diversification means a lot more than the ‘don’t put all your eggs in one basket’ formula. There are other types of diversification that only expert investors usually know about.

Here are some different types of portfolio diversification that you should know about, as they could help you improve your investment strategies

  1. Individual company diversification

The fundamental idea of diversification is to create a portfolio with several investments. This reduces the total risk. For example, Shanti’s portfolio only consists of the shares of company X. What if X’s shares tumbled? That would hit her entire portfolio. But, what if she had divided her investment between two or more companies? She could have reduced the potential risk to her portfolio.

Economist Harry Markowitz proved that a portfolio’s risk dropped significantly when an investor added more stocks to it. This is why Mutual Funds offer the benefit of diversification. By investing across different stocks, an Equity fund automatically diversifies a portfolio.

Related: Simple ways in which you can diversify your financial portfolio

  1. Industry diversification

Apart from investing in different stocks, picking stocks from various industries is another way to diversify a portfolio. This is ‘industry diversification’. Different industries and sectors react to the market in different ways. For example, if the BSE Sensex fell by 200 points on a particular day, it might not affect the stocks of all industries. It is likely that this drop could only be limited to one industry, while the others remain unaffected. So, consider the option of investing in stocks from more than one industry. Sector funds are a type of diversification that allows investing across different sectors.

  1. Asset class diversification

The risk and returns that different asset classes offer, tend to vary. Stocks are riskier than bonds, but they have potential to give higher returns. These assets’ performances may vary in different economic environments. For example, during market bull runs, the equity portion of your portfolio can deliver superior returns. But when markets go through a bear phase, debt investments can lower the risk of losses. Having different assets in a portfolio, is therefore, a smart decision. Balanced funds, for example, can help lower risk through asset allocation.

Related: Dummies guide to Mutual Funds

  1. Strategy diversification        

Different strategies can be used while investing. For example, one strategy can be choosing high-dividend-paying stocks. Another strategy could be reinvesting dividends and profits to get better returns. Picking stocks of ‘cyclical’ companies at certain times and ‘defensive’ stocks at other times, is yet another strategy. The trick to these strategies is getting the timing right. In such cases, consider a mix of these strategies, depending on your goals. This helps diversify investments to earn better returns, and lowers risks.

 

  1. Geographical diversification

Many investors only buy stocks of companies based in their home countries. In investment terms, this is called ‘home country bias’. But, what if there is an economic slowdown in the home country? The entire market in the country could crash. Going global, thus, makes a lot of sense. Countries that have potential to grow and deliver returns, can help earn better returns in the long run. This can be done through mutual funds that invest in different countries.

Related: How debt and equity based mutual funds differ in risk

  1. Time diversification

It is not unusual for investors to lose money in the market once or twice. This could be caused by various reasons such as speculation, wrong timing, or lack of investment discipline. But this should not mean they should stop investing.

Consistent and disciplined investments can help make the most of the market’s highs and lows. For example, rupee-cost averaging can be quite beneficial for investors. In this strategy, investors invest a particular sum at regular intervals, without having to think about the price. When the price falls, they get more shares, and when the price rises, they buy fewer shares. This can result in a lower average cost per share in the long run, and is called ‘time diversification’. Systematic Investment Plans (SIPs) of mutual funds offer precisely this benefit.

The bottom line:

There is more than one way to diversify a portfolio so that investors can get the best from their investments. However, it is important to weigh all the options, and consider the various risks and benefits before making a choice. 

 
 

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