The word 'diversification' comes up frequently in the context of investment. It essentially refers to the process of spreading financial risk by putting money in a varied range of investment categories, as opposed to concentrating it in a few areas. Experts consider diversification a healthy strategy for managing one's portfolio.
So why is diversification necessary? In any market, different asset classes do well at different times. One year, large cap equities might perform well and mid and small-caps might not. The next year, gold might be the best investment, while real estate could under-perform. If all your money is in one basket, your exposure to risk from that asset is much higher.
Let's say, for example, that you invest all your money in automobile stocks. The authorities announce a steep new tax that sends car prices zooming, and consequently, demand crashes. This brings down the share prices of auto stocks (at least temporarily), and reduces the value of the shares you hold. Now, imagine another scenario where you have deployed equal shares of your funds in auto and banking stocks, infrastructure bonds, and gold. It is extremely rare that all four asset classes would fare badly simultaneously. Hence, the volatility in one asset class is offset by the stability or growth in other classes.
Types of diversification
Diversification can be vertical or horizontal in nature. When you invest in a range of different assets (such as bank fixed deposits, equity markets, mutual funds, pension plans, gold, debt instruments, real estate, etc.), it is called vertical diversification. Each of these is a unique class with defining characteristics. Alternately, you can diversify horizontally by investing in a multi-cap mutual fund that spreads your money across small, medium and large-cap firms. Investing in a mix of long and short-term debt is another example of horizontal diversification.
So is diversification an assurance of good returns? No. It is merely a measure to protect one's capital by minimising market risk. Also, there are situations where diversification simply doesn't work—like when there is a financial crisis that affects the overall economy. However, this is not applicable to a mature, stable and growing economy like India.
So now that we have seen that diversification makes good financial sense, let's talk about the factors that determine the extent to which one should 'spread out' one's portfolio.
Factors determining diversification strategy
An investor's diversification strategy can depend on multiple factors, such as expertise, risk appetite and corpus size. People with a high level of financial expertise may not always spread their money around in multiple instruments. That's because their experience and knowledge allows them to create wealth by concentrating on fewer investments. However, for regular individuals who have a basic or working knowledge of the markets, diversification is a sound strategy for protecting their investment corpus.
Risk appetite is another factor. People who prefer stability usually allocate more money towards fixed-return schemes, government savings schemes, real estate or gold, while reducing exposure to equity, which is considered riskier. The opposite would be true for investors with greater stomach for risk, or for younger investors, who can absorb risk to a greater extent.
The balancing act
Diversifying your portfolio is not a one-time affair. Every few months or years, the markets throw up new opportunities or risks. A good investor will always evaluate which parts of his or her portfolio are lagging, and which ones are doing well. The portfolio can accordingly be reshuffled in favour of better-performing instruments. If you do not have the expertise for this, get an advisor to assist you. Also remember not to get over-zealous in your desire to spread your money. Investing in dozens of different categories can stretch your money too thin, and limit the potential gains from those investments.
Diversification is a key tool in managing your investments, because it protects your hard-earned money from market ups and downs. However, deciding how exactly to split your capital between different categories can be difficult if you don't have the know-how. That's where mutual funds have an advantage. Mutual fund schemes invest in a basket of securities, which helps minimise the risk of one particular security's under-performance. For more information, check out the recent 'Mutual Funds Sahi Hai' campaign by The Association of Mutual Funds in India (AMFI).
Mutual fund investments are subject to market risks, read all scheme related documents carefully.