These are the words which many of you may have heard often while investing. Diversification has been widely talked about for the merits it offers, but quite often incorrectly or incompletely followed by many investors.
It is noteworthy that diversification is one of the basic tenets of investment planning, and therefore vouched by many investment advisors. It helps one in reducing the risk to one's portfolio, and thus makes it resilient. But having said that you need to diversify in a prudent manner which can thus aid you to cushion against the wild swings of the markets.
Very often, through experience we can say that many investors often keep buying various stocks, mutual funds and debt instruments on an ad-hoc basis, and believe that they are diversifying their portfolio. But, in our view unless you don't do it the effective way, it is meaningless and cannot add value to your overall portfolio.
The legendary author on investments- Mr Robert Kiyosaki has so beautifully said, "Your future is created by what you do today, not tomorrow." And thus in context to that, it is indeed imperative that you as investors learn to diversify wisely in the following way:
1. Diversify across asset classes
Yes, it is important to diversify your portfolio across asset classes, since all assets don't move in the same direction. Thus while you may have a high risk appetite and therefore investing in equities, you ought to have exposure to other asset classes- such as debt, gold and real estate as well. This helps you to reduce the overall risk of wealth erosion to your portfolio.
So, say when the Indian equity markets turn turbulent (as they are at present for instance), allocating your hard earned money into debt instruments such as fixed deposits (FDs) and fixed maturity plans (FMPs) can prove to be handy.
However while you diversify across classes, allocate your assets the smart way . Take into account factors such as your age, income, expenses and nearness to goals, which can help you build a rationally diversified portfolio across asset classes. Also, you may follow a diversification model based on your risk profile. Thus say if your willingness to take risk is high (aggressive), you can skew your portfolio more towards the equity asset class. Similarly, if your willingness to take risk is relatively low (conservative), your portfolio can be skewed towards fixed income instruments, and if you are a moderate risk taker you can take a mix of 60:40 into equity and debt respectively.
2. Diversify across investment avenues
Within each asset class too, there is a need to be diversified across various investment avenues. Thus say for example; while your risk profile allows you to participate with a dominant composition towards equities, you ought to diversify well between stocks and mutual fund schemes. Moreover, within stocks and mutual fund schemes too, there needs to be optimal diversification, which can help you to reduce risk as well as create wealth. Hence, care should be taken that you don't over-diversify your portfolio nor make it concentrated either, by holding too many or too little stocks and mutual fund schemes in equity.
Similarly for debt composition of the portfolio too, care should be taken to diversify across various debt instruments such as bank FDs, corporate FDs, debt mutual funds (suiting your needs) and small savings schemes.
3. Diversify across time horizons
You should hold multiple investment portfolios each catering to a distinct need and running over a commensurate time horizon. For example, as an investor you could have short-term goals (going on a vacation), medium-term goals (buying a house) and long-term goals (providing for retirement). Each of these objectives should be backed by a distinct portfolio and the investments therein should be aligned with the time frames. Equities can account for a higher composition for a long-term portfolio given that they are best equipped to deliver over longer time frames. Conversely, debt instruments could dominate the short-term portfolios.
4. Diversify across issuer of securities
Very often we come across investors who have invested in securities only of some issuers, either believing they are safe, or due to mere penchant for the issuer. It is vital to note that investing is a serious business, and thus it is important to keep emotions at bay and invest rationally.
While you build a portfolio, it is imperative that you diversify across various issuers (i.e. providers or suppliers) of securities, or else you'll be provoking the risk of concentration. Thus for example, although you may be fond of investing in stocks bearing a 'Reliance' tag, you ought to prudently select them through thorough analysis. Likewise in mutual funds schemes as well, you ought to invest across Asset Management Companies (AMCs), and not merely because it comes from a big or renowned fund house. It is noteworthy that each AMC can offer a unique investment style and process, thereby aiding the portfolio on the diversification front. Moreover, it is vital to select winning mutual funds prudently for your portfolio , rather than merely going by what your friends, family and colleagues say.
Similarly while investing in debt instruments too; one should diversify across issuers of securities. Thus for example while you would like to plough your hard earned money into FDs, you should look out for issuers such as various bank and corporates.
5. Diversify across countries
Today, with resident Indians being permitted to invest in assets and securities abroad, subject to the regulations issued by the Reserve Bank of India (RBI), your scope for diversification has further more widened, since you now diversify across countries. However, while undertaking diversification for your portfolio you ought to be cognisant about the economic scenario in the global economy- and more specifically the country which you would like to have exposure to. Also, you got to be well-versed with the tax implications, because unless meaningful tax-adjusted returns aren't obtained, wealth creation would be muted, although one may get a unique diversification edge.
Don't forget to rebalance your portfolio…
It is noteworthy that any attempt to diversify comes to a zilch, if it is not followed by disciplined portfolio rebalancing. Rebalancing isn't easy and thus many often fail to rebalance their portfolio in the right manner. It involves re-alignment of the portfolio, and what's optimal re-alignment is not known to many. For example you may have suitably diversified your portfolio in accordance to time horizon, by investing for the long-term to take care of your retirement. But unless you don't re-balance your portfolio by shifting from risky asset classes to safer asset classes as you are close to about three years away from your financial goal, you are assuming more risky and may cause harm to your portfolio.
Hence, one should remember that diversification and re-balancing are both integral to the art of investment management and utmost necessary.
PersonalFN is a Mumbai based Financial Planning and Mutual Fund Research Firm.
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