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Importance of Diversifying One's Portfolio
It is said "Never put all your eggs in one basket". This may be a frequently used cliché but holds very true when it comes to investing. Imagine you had put 100% of your savings in the stock market in 2007. In that case you would have suffered a huge loss in the next 2 years in 2008-09, giving you enough reason to worry! One of the most effective ways of reducing such a risk is to bring variety into your investments or diversify your investments.
A diversified portfolio has a mix of varied asset classes like equities, debt, cash, real estate, gold, etc. Even within these asset classes, investments can be further diversified based on sectors, geographies, and other factors. Why is this diversification so important? Let’s find out.
Why Diversify?
The objective of diversification is not to guarantee returns or eliminate risk. It does not ensure high gains or prevent loss of investments. Diversification casts a safety net that reduces your investment risks to a certain degree and enables you to limit your losses by optimising your returns.
Benefits of Diversification
Helps reduce risk
No one can accurately predict how an asset class will behave or generate returns in the future. By spreading your investments across different classes like equities, bonds, cash and real estate, you are reducing your portfolio risk. A portfolio can also be diversified within each category. For example, even in equities, investing in different stocks across varied sectors or market cap would mean different categories with different risks. This ensures that the loss in one category is offset by high returns in the other, reducing the overall risk. Similarly, within the debt segment, you can consider investments with varying maturities and sensitivity to interest rates.
Helps you avoid the losses arising due to bad timing or investment decisions
The advantages of a well-diversified portfolio can certainly be seen over the long-term. Many investors get swayed by market movements and land up taking emotional decisions instead of following financial discipline. People tend to participate in the markets when they are climbing higher and panic when they see their investments losing value, wanting to sell them out. It causes the investment portfolio to generate far lower returns than the market average. Maintaining the optimum level of risk and diversification in your portfolio will ensure that the financial discipline pays off and prevents or offsets any loss arising in the long-term.
Diversify based on an asset allocation that is right for you
Asset allocation is an essential tool in diversifying your investment portfolio. It refers to getting the right mix of investment options aligned to your risk profile, life stage or age and time horizon. Making regular checks or ‘rebalancing’ ensures that your risk tolerance is maintained and your investment portfolio meets your investment goal.
Diversification of your investment portfolio based on an asset allocation strategy that is right for you is the key to wise investing. Further, monitoring your investments and rebalancing your portfolio to maintain the desired asset allocation can go a long way in realising your investment goals.
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If you are unsure about the diversification strategy that would work for you, look at balanced funds or diversified funds, based on your risk level, that implement the diversification principle for you.
Look at various investment categories that have a low correlation to each other for optimum diversification.
Guard against over diversification or rebalancing your portfolio too often.
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