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Ever wondered why everyone says, "Don't put all your money in one place"? It's because spreading your investments (also known as diversification) can make a big difference in how your portfolio handles risk and market ups and downs.
In this blog, we'll walk you through what portfolio diversification means, how it works, why it's important, the different ways to diversify, how it's different from asset allocation, and more.
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Portfolio diversification is an investment strategy that distributes capital across multiple assets to reduce overall risk in a portfolio. By spreading investments rather than concentrating them in a single asset, the impact of any investment that could perform poorly is reduced.
Generally, portfolio diversification is commonly achieved across major asset classes such as Equities (stocks - domestic and global), Fixed Income securities (bonds), Commodities, and REITs/InvITs. But, not necessarily asset-wise. This diversification is also possible across time horizons, industries or sectors, and geographic regions, depending on an investor's objectives and risk tolerance.
After understanding portfolio diversification, knowing how it works is the next step.
The first step in portfolio diversification is learning the level of risk you're comfortable taking. Based on your risk appetite, the asset classes can be explored and included in the portfolio.
Considering your risk appetite, the next step is identifying the asset classes you wish to invest in – such as equities, fixed-income instruments, commodities, and REITs/InvITs. Each asset class has its own risk and return characteristics.
Instead of investing the entire amount in a single asset or stock, the investment is distributed across multiple assets. This investment strategy of spreading investments is known as "Portfolio Diversification." This helps reduce dependence on the performance of any one investment.
Diversification does not stop at asset classes. Investments can also be spread within an asset class. For example, within equity, diversification can occur across sectors, industries, and companies to further reduce concentration risk.
Each asset contributes differently to portfolio risk. By combining assets with varying risk profiles, the overall portfolio risk can be better managed than with a single investment.
Over time, asset values do change, and the portfolio's performance may also drift. Hence, periodic review and rebalancing help maintain the desired level of diversification in line with investment objectives and risk appetite.
Portfolio diversification and asset allocation are closely related concepts, but they serve different purposes in portfolio construction.
| Aspect | Portfolio Diversification | Asset Allocation |
|---|---|---|
| Purpose | Spread investments across different assets to reduce concentration risk. | Decide the proportion (%) of funds to invest in each asset class. |
| Focus | Where to invest (range of assets: stocks, bonds, commodities, etc.) | How much to invest in each chosen asset |
| Goal | Minimize risk and balance portfolio performance. | Align investments with financial goals, time horizon, and risk tolerance. |
| Example | Investing in equities, bonds, gold, and cash. | Allocating 60% to equities, 30% to bonds, 10% to cash. |
In short, diversification sets the investment universe, while asset allocation determines the weightage of each investment within the portfolio.
In general, there are some common portfolio diversification strategies to take note of:
As the name suggests, this method of diversification allocates capital across various asset classes - such as equities, fixed income instruments, commodities, REITs, and InvITs.
Since each asset class responds differently to market conditions, this approach helps reduce dependence on any single asset class.
Over here, equity investments are spread across multiple sectors/industries rather than concentrated in a single sector/industry. This helps limit the impact of sector-specific risks on the overall portfolio.
Geographic diversification involves investing across different regions or countries. For example, including global funds/ETFs (or international funds), along with domestic investments. It helps reduce the exposure to risks arising from economic, political, or regulatory changes within a single nation, but also captures opportunities created within the global market.
Within equities, investments can be further diversified across large-cap, mid-cap, and small-cap companies.
Investments may also be diversified across different styles, such as Quality, Growth, Low Volatility, Value, and Momentum (QGLVM), depending on the fund manager's philosophy.
After considering all of the above types (asset-wise, market-cap-wise, geographical, etc.), it is also crucial to maintain an allocation proportion (or weightage) to avoid overexposure to any instrument.
Let's say an investor has ₹10 lakh to invest. Instead of investing the entire amount in a single asset or stock, the investor diversifies the portfolio across different asset classes:
Diversification, however, does not stop at the asset-class level. Investors can also diversify within each asset class to further reduce concentration risk.
For example, within equities, investments can be spread across different market capitalizations (large-cap, mid-cap, and small-cap), sectors, themes, or even geographies. This ensures that the equity portion of the portfolio is not overly dependent on a single company, sector, or market segment.
Similarly, fixed income investments can be diversified across instruments with different maturities or issuers, adding another layer of balance to the portfolio.
Now that we understand what portfolio diversification is, it is equally important to know why diversifying a portfolio matters and how it can influence overall investment outcomes.
One prime benefit of diversification is that it helps reduce over-concentration in a single asset, sector, or investment.
Portfolio diversification involves allocating capital across different asset classes rather than investing in a single stock or instrument. It extends the exposure to varied investment opportunities with different risk and return characteristics.
When investments are diversified, poor performance in one asset may be offset by relatively better performance in others. It can contribute to more balanced and stable portfolio outcomes over time.
By avoiding excessive exposure to a single investment, the portfolio may deliver steadier results relative to the level of risk undertaken. In short, diversification balances risk and potential returns.
Different assets react differently to market movements. And deploying portfolio diversification helps reduce the impact of sharp market fluctuations on the overall portfolio during volatile periods.
In the event of unforeseen or sudden events affecting a particular stock, sector, or asset class, the overall impact on the portfolio may not be significant, as investments are diversified.
Various asset classes perform differently across economic and market cycles. Diversifying helps reduce reliance on the performance of any single cycle or trend.
A diversified portfolio allows for periodic rebalancing to maintain the desired asset allocation. Rebalancing may be done at regular intervals or as determined by the portfolio fund manager, based on investment objectives and risk appetite.
While portfolio diversification is widely accepted, managing it independently can be challenging for many investors. Also, building and maintaining a diversified portfolio requires ongoing monitoring, informed decision-making, and timely adjustments, which may be difficult to manage without sufficient time or expertise.
That's where a Portfolio Manager brings professional expertise and market knowledge to design, diversify, and manage your portfolio. They continuously assess market conditions and portfolio exposure to ensure diversification remains effective for your needs.
By managing diversification for investors, portfolio managers help keep portfolios aligned with changing market conditions and long-term goals, while reducing the effort required from individual investors.
As we've seen, diversification is crucial to build a balanced portfolio based on your risk appetite. It helps reduce overdependence on a single asset class, smooths the impact of market volatility, and manages uncertainty more effectively. That's exactly what Portfolio Management Services (PMS) aim to achieve.
By applying professional expertise, disciplined asset allocation, regular portfolio reviews, and timely rebalancing, PMS services help keep portfolios aligned with changing market conditions and long-term goals. For better clarity on what suits your needs, consult a financial advisor or PMS provider.
Not necessarily. Unless you're looking for a professional or you lack the time and knowledge to manage and rebalance your investments, you can do portfolio diversification on your own.
Diversification helps manage risk, but it does not guarantee higher returns. By spreading investments, extreme gains from a single asset may be balanced by other assets. Thus, overall returns may be steadier but lower than a high-risk, concentrated investment.
Here's how you can start diversifying your own portfolio as a beginner:
Disclaimer: The information provided in this article is for educational and informational purposes only. Any financial figures, calculations, or projections shared are solely intended to illustrate concepts and should not be construed as investment advice. All scenarios mentioned are hypothetical and are used only for explanatory purposes. The content is based on information obtained from credible and publicly available sources. We do not guarantee the completeness, accuracy, or reliability of the data presented. Any references to the performance of indices, stocks, or financial products are purely illustrative and do not represent actual or future results. Actual investor experience may vary. Investors are advised to carefully read the scheme/product offering information document before making any decisions. Readers are advised to consult with a certified financial advisor before making any investment decisions. Neither the author nor the publishing entity shall be held responsible for any loss or liability arising from the use of this information.
