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Importance of Diversification
We have all heard the proverb "Never put all your eggs in one basket". In investment terms, this adage reflects what diversification is all about. Indeed, diversification is the one of the most important aspects of building a sound investment portfolio. Having your money distributed in a wide variety of investments instruments is essential as a strategy to spread risk. If you invest all your money in a single instrument and that investment fails, you are in serious trouble. On the other hand, if you have your money distributed in multiple investments, you still have the other investments to fall back on.
With mutual funds, your investments are diversified with each fund holding a diverse range of stocks and bonds. To take this diversification further, you can invest in different types of funds. Picking a few good funds can go a long way in achieving diversification on a broader platform without you having to pick stocks individually.
Diversification is essentially a risk mitigation strategy – the higher the risk of your investments, the more important diversification becomes to spread the risk. Diversification of portfolio involves building a portfolio that includes instruments from different asset classes. Depending on your tolerance for risk, you can choose safer or riskier investments in each asset category. It is therefore wise to build a portfolio that includes a mix of stocks, bonds, cash, real estate and commodities. This helps increase your chances that at least a portion of your portfolio will be performing well even if other portions are lying low. The trick is to hold a variety of investment options such that individually they are unlikely to increase or decrease in price at the same time.
For example, equities carry high risk but also have the highest potential to give high return over the long-term. On the other hand, government securities have low risk as they are backed by the government, but they also provide the lowest potential return. Since different asset classes have varying risks and experience different market fluctuations, proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities.
Asset allocation is essentially a diversification approach wherein investments are spread, or diversified, across various asset classes. Asset allocation can have a significant impact on the returns a portfolio generates. To ensure an investment portfolio obtains desired results over a long term, it is important that the asset allocation is appropriate for your investment goals and your tolerance to risk. Through asset allocation, you can ensure your risk is managed at various levels:
o Diversified investments across asset classes
o Further diversify within each asset class across a number of investments. For example, instead of investing directly in stocks, you can choose mutual funds that invest in at least 15-20 companies rather than investing in just 3 or 4 companies alone.
Through a diversified spread of investments, you can mitigate risk by minimising the impact of underperformance in any single instrument on your overall portfolio. A good spread of investments also widens the scope of opportunities you can participate in, thus increasing the potential for you to achieve your goals and objectives.
In practice, it is difficult to create the right balance of asset classes to suit your specific goals and risk profile. Consult your financial advisor for a customized and suitable asset allocation plan.
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