Role of Diversification in an Investment Portfolio

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Importance of investment portfolio diversification

When you start investing, you define your financial goals, risk preference and time horizon of investment. Based on these, you choose the asset classes that you want to invest in. Then comes the most important aspect of investing, creating a diversified investment portfolio. Most successful investors recommend diversified investments or portfolio diversification as the secret to generating wealth.

What is a Diversified Investment Portfolio?

Diversified Investment Portfolio

These are the three important terms:

  1. Investment
  2. Portfolio
  3. Diversified

An investor might choose to invest in multiple asset classes like gold, real estate, equity, debt, etc. This decision is based on the definition of financial goals and risk preference of the investor. The collection of all these investments (across all asset classes) is called an Investment Portfolio.

Diversification has been the mantra of investments since the farm maid dropped a basket full of eggs. For those who don’t know the story, here it is:

“Once there was a farm maid who collected the eggs in the morning and put them all in one basket. On her way back, she accidentally dropped the basket causing all the eggs to break.”

Moral of the story – Don’t put all your eggs in one basket!

Coming to investments, if you invest a major chunk of your money in a particular asset class, then you expose yourself to possible losses of the asset class. Hence, investment diversification is highly recommended as a hedge against losses due to overexposure to one asset class.

Summing up, when you invest, ensure that you diversify your investments and create a portfolio to monitor and manage them effectively. Such a portfolio is called a Diversified Investment Portfolio.

READ THE IMPORTANCE OF SAVINGS AND INVESTMENTS

Asset classes for Investment portfolio diversification

There is no one-size fit approach in investments. Every investor is unique and requires a different investment diversification strategy to achieve his/her financial goals. The portfolio should be built by considering the financial goals and risk appetite of an individual investor Depending how comfortable you are with determining the asset allocation it is advisable to consult an investment advisor. Some commonly used asset classes are:

  • Equity
  • Debt
  • Gold
  • Real Estate
  • Bonds
  • Crowdfunding, etc.

Just remember to diversify your investments optimally. Don’t try to invest in each of these asset classes. While a lack of diversification exposes you to too much risk, over-diversification makes it very difficult to monitor your investments and generate returns Hence, your diversified investment strategy must centre on finding the right balance.

Benefits of a diversified investment portfolio

While portfolio diversification offers a plethora of benefits, here are the top three that cannot be ignored:

  1. Minimizing risk – Let’s say that your investment portfolio has equity, debt, gold and real estate. Now, if equity markets perform poorly, then the amount invested in those shares might pose a potential loss to your portfolio. However, being diversified ensures that one of the remaining asset classes will make enough returns to minimize the effect of poorly performing asset class on your overall returns.
  2. Capital Preservation – While some investors aspire for capital appreciation, capital preservation is equally important. Diversification allows you to protect your capital by allocating it to different asset classes.
  3. Better returns – By diversifying your source of income and return you enhance your risk-adjusted returns.

Summing up

An investment portfolio should be constructed to best meet personal investment goals and financial needs of an individual. Each investor’s risk & return objective should be taken into account when allocating capital to different asset classes. As one of the famous quotes says 

“The beauty of diversification is it’s about as close as you can get to a free lunch in investing” – Barry Ritholtz

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