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Portfolio Diversification Definition & Purpose - All You Need to Know About - ABSLMF Blog

All You Need To Know About Portfolio Diversification

Dec 12, 2018
7 mins | Views 4046

It’s late in the afternoon at work. Nafisa and Ritu are sipping their afternoon tea. Ritu looks confused.

Ritu: Hey Nafisa. The other day my friends were talking about financial assets, portfolio and portfolio diversification. While I invest my money myself, I know nothing about portfolio diversification. Do you have any idea about this?

Nafisa: Of course I do. You know how I take care of my entire family’s investment. But before I explain about portfolio diversification, tell me - what do you understand by the words financial assets and portfolio?

Ritu:Ritu: Well I think financial assets include investments products like stocks, bonds, bank deposits, corporate deposits, public provident fund, mutual funds, cash equivalents etc. And a portfolio is the grouping of these financial assets.

Nafisa: Superb! And what do you understand by the word diversification?

Ritu: Well, the literal meaning of diversification is expansion, isn’t it?

Nafisa: Yes. But if you want to describe it in the language of finance, diversification means the process of investing in different types of investments, or allocating your assets across various investment products. This is done to minimize your risks from having all your money in one kind of investment. Remember the saying ‘Don’t put all your eggs in 1 basket’? This is a financial equivalent of the same!

Ritu: Right. So, then portfolio diversification means I should invest my money across equities, bank deposits, bonds, gold etc?

Nafisa: Perfect. That way, in case the return from your one investment goes down, returns from other investments will make up for it. This way you minimize the risk to your capital.

Ritu: Ok and the purpose is risk management?

Nafisa: Yes, the purpose of portfolio diversification is portfolio risk management. When you make an investment, you expect to get some returns from that investment in the future. However, just as our future is uncertain, so are future expected returns from any investment. It is the uncertainty associated with the returns from an investment that is the risk factor. In most cases the more the potential return of an investment, the higher the risk involved. But there is no guarantee that you will actually get a higher return by accepting more risk. A diversified portfolio could enable you to reduce the overall risk of your portfolio without sacrificing potential returns.

Ritu: That sounds complicated. Can you explain with an example?

Nafisa: Ok. To illustrate, suppose you wish to invest Rs 10,00,000 for 10years. To achieve the best portfolio diversification, you would need to invest this money in various investment products. Now, your risk appetite and investment horizon will help you decide what kind of investment products you should choose and how much amount should be invested in each of them to generate optimum long-term returns.

Since you are in your 20s & investing for long term, your diversification strategy could then be something like this:

Once you decide the investment type and proportion, you can further zero down the best products available in each category for investing your money. Here are few things to keep in mind:

  • If you have an expertise to research and invest directly in equity, then you could invest a portion of your “equity” money in 8 to 10 diversified stocks on an average from different industries and sectors. By doing this, your risk could be leveraged.
  • Mutual Funds are convenient for individual investors like us because they require comparatively less research & monitoring and offer the advantage of professional management by experts. You could select and invest “equity” portion of your money in various equity oriented funds.
  • For the debt part, you can invest either in traditional saving products or debt mutual funds. While traditional savings products provide you safety, debt mutual funds aim to give tax efficient returns.
  • For the gold portion, you can either buy physical gold (not in jewellery form since you are investing) or invest money in Gold ETFs or any other form of digital gold.

The point is to include all type of investments which are suitable to your profile but with different levels of risk. Remember the most important factor. Diversify but don’t over-diversify. Some investors think that the greater the diversification, better the results, which is a myth.

And finally, if all this sounds too complicated, you can research and invest in 4-5 mutual fund schemes of different types – Equity, Debt, Gold ETF. This could also be an excellent diversification because Mutual Fund schemes offer diversification across investment styles, sectors, and countries and even offer combination of different investment types. But investing in anything more than 4-5 mutual funds may not be a sound diversification strategy because a certain type of fund will broadly cover its universe of stocks/bonds; another fund of same type may also have exposure in the same universe which may create duplication not diversification.

Ritu (with a smile): Thanks, Nafisa for being such a good teacher. Now I know what portfolio diversification means.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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