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Is Diversification A Prudent Strategy?

Is Diversification A Prudent Strategy?

One of the often used terms in investing is diversification. Diversification is the process of spreading investments across different asset classes, industries and geographies to reduce the overall risk of an investment portfolio. The idea is that by holding a variety of investments, the poor performance of any one investment potentially can be offset by the better performance of another, leading to a more balanced overall return. Diversification thus aims to include assets that are not highly correlated with one another.

Most investment professionals agree that although it is not a guarantee against loss, diversification is an important component for achieving long-term financial goals while minimising risk. Now, let us consider how one can go about involved. creating a diversified portfolio. To begin with, diversification reduces risk by investing in vehicles that span different financial instruments, industries and other categories. The action of proactively balancing your portfolio across different investments is at the heart of diversification.

Instead of attempting to maximise your returns by investing in the most profitable companies, you enact a defensive position when diversifying. To understand this, let us consider an example. Imagine a scenario where fuel prices are heading higher. This means airline stocks can come under pressure. As a means to mitigate this development, one can move out of airlines or even the transportation industry and instead consider investing in an oil marketing company. Remember, risk most often is not industry-specific but company-specific.

For instance, imagine a company with a revolutionary leader. Should that leader leave the company or pass away, the company will be negatively affected. Similarly, risk can be in the form of legislation, acts of nature or consumer preference. As such, one may have a favourite airline that one usually flies with, but if you are a strong believer in the future of air travel, consider diversifying by acquiring shares of different airline companies. This applies to any product or service, as for instance, when buying a stock of an IT company, take into consideration the trends the IT industry is going through.

Diversifying Across Asset Classes

The most common asset classes often spoken about include equity, debt. commodities, real estate, etc. Each of these asset classes behave or react differently to a macroeconomic development. For example, if the central bank raises interest rates, the equity markets may perform well due to the relative strength of the economy. But debt will be adversely impacted as bond prices will head lower. So, on a portfolio basis, to mitigate any adverse impact, it is imperative to have a well-diversified portfolio.

Diversifying Across Geographies

Different countries operating with different monetary policy provides different opportunities and risks. For instance, consider how a legislative change to corporate tax rates could negatively impact all entities within India. For this reason, consider broadening your portfolio to include international companies operating across different geographies.

Diversifying Across Timeframes

At the time of considering investments, give a thought to the investment timeframe. A long-term bond often has a higher rate of return due to higher inherent risk, while a short-term investment tends to be more liquid and hence yields are lower. An airline manufacturer may take several years to work through a single operating cycle while your favourite retailer might post thousands of transactions using inventory acquired the same day. In general, assets with longer timeframes carry more risk but often tend to deliver higher returns to compensate the risk involved.

Pros and Cons of Diversification

The pros include:
  • Attempts to reduce portfolio risk
  • Potentially increases the risk-adjusted rate of return
  • Preserves capital, especially for retirees or older investors
  • May garner better investing opportunities due to wider investing exposure
  • May cause investing to be more fun and enjoyable if investors like researching new opportunities.
The cons include:
  • Generally leads to lower portfolio-wide returns
  • May cause investing to feel burdensome, requiring more management
  • Can result in more or larger transaction fees
  • Does not eliminate all types of risk within a portfolio
  • May turn your attention away from large future winners
  • May be intimidating for inexperienced investors

To conclude, diversification can help an individual investor manage risk and reduce portfolio volatility. However, remember, that no matter how diversified your portfolio is, risk can never be eliminated completely. The key is to find an optimal balance between risk and return. This ensures you achieve your financial goals while still getting a good night's rest.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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