Portfolio Diversification: Why It Matters and How to Do It?

Table of Contents

• What is Portfolio Diversification?
• Benefits of Portfolio Diversification
• What are the Various Methods of Portfolio Diversification?
  • Asset Class Diversification
  • Sector Diversification
  • Geographical Diversification
  • Time Diversification
  • Company Diversification
  • Individual Securities Diversification
• Key Factors to Consider for a Successful Diversified Investment Portfolio

What is Portfolio Diversification?

Portfolio diversification is a way of investing in different assets, industries, etc., to reduce the risk of loss during market fluctuations. Instead of putting all your eggs in one basket, portfolio diversification can help cover up the poor performance of any one investment by the better performance of another. This leads to a more consistent overall return for your investments. Portfolio diversification is a major part of achieving financial goals with minimum risk.

Benefits of Portfolio Diversification

Portfolio diversification helps in managing risk and getting long-term returns. These benefits have been discussed in detail below.

Reducing Risk

The objective of portfolio diversification is to protect your investments against loss. By avoiding investing all your funds in one asset class, you reduce the risk of poor performance in the long run. If a single investment does not do well, then the other ones may do well and help maintain stability.

Balancing Market Volatility

A diversified portfolio helps manage market volatility by investing in a range of assets. This helps achieve growth and maximize returns on portfolios.

Protection During Inflation

Portfolio diversification can also protect against inflation because different asset classes may perform differently during inflation periods. Investing in a wide range of assets that have a proven track record of doing well during inflation can help keep the investment safe.

What are the Various Methods of Portfolio Diversification?

A number of strategies are available for portfolio diversification, like asset class diversification, sector diversification, etc. Some of the major ones have been discussed below:          

1. Asset Class Diversification

Putting investments into different asset classes like stocks, bonds, etc., reduces the exposure to any single asset class's risks. Each of these asset classes has its own risk and returns. For example, it is generally considered that equity have higher risk than debt. However, equity fund returns are generally higher than debt fund returns.

Real estate, commodities, private equity, venture capital, and precious metals usually come under alternate assets. Investing in alternate assets reduces the impact of public market volatility because usually they are not closely related with traditional stocks and bonds.

2. Sector Diversification

Different sectors & industries such as IT, consumer goods, healthcare, banking, finance, etc., can be used for investment purposes. Spreading your investments in different sectors can help mitigate the risks associated with specific sectors. For example, global slowdown and government policies affect the IT sector which will also reflect in your portfolio. For such conditions, investment in other sectors can help reduce the risks an manage your portfolio.

3. Geographical Diversification

Investing in different countries around the world is known as geographical diversification, and it offers global growth opportunities. Political, economic, and social factors of a nation can affect the investments made in that region, so diversifying the investment across the world can reduce the risks associated with such situations.

4. Time Diversification

Investing for longer time periods can bring down the impact of short-term market volatility, and this can increase the chances of getting consistent returns. A longer time frame allows compounding to work in an investor's favour and leads to growth in wealth over time.

5. Company Diversification

Putting your investments in different market capitalizations like large cap or mid cap or small cap stocks can provide long-term growth and reduce risks. The total market value of the outstanding shares of a company decides whether they belong to large, mid, or small cap.

Investment in large-cap companies provide stability and consistent returns but may have slow growth. In mid-cap companies there is a balance of growth and stability, but small-cap companies have high growth potential with increased risk.

6. Individual Securities Diversification

Instead of putting all the money into one company’s stock, investing in shares of different companies can help avoid the risk of loss. If one company does not perform well, then it will not affect the entire portfolio investment.

Key Factors to Consider for a Successful Diversified Investment Portfolio

Many factors, including financial and personal goals, risk-taking ability, etc., affect the diversification of a portfolio. We have discussed some major points to consider before portfolio diversification.

• Goals: Your investment goals should be clearly defined, as they will help you choose the assets accordingly and the diversification strategy will change on account of that. If you are saving for retirement, you will consider bonds and dividend paying stocks to get a steady income and reduced risk. Long-term goals can also handle more risk and provide potentially higher growth. On the other hand, short-term goals need stability and liquidity to avoid potential losses.
• Risk: You should know your risk-handling capabilities to withstand market fluctuations without making impulsive decisions. A well-diversified portfolio, which includes both high-risk assets like stocks and lower-risk options such as bonds, can be beneficial in such situations.
• Asset Correlation: Put your investments in different types of assets like stocks, bonds, commodities, etc. This ensures that the portfolio’s movement is not in one direction at any given time. Different assets move differently in the market; some might go up, and others might go down. In the long run, it helps reduce overall risk and make the portfolio stable.
• Rebalancing: Portfolio rebalancing is done by adjusting the investments in different asset classes because it makes sure that the investment goals are met and any kind of risks are reduced. Also, if there are some major profits in the portfolio, then the extra profits can be reinvested in other assets. Time-to-time adjustments are required to balance a diversified portfolio.
• Research: Previous performance of assets and an understanding of market conditions can help select assets that have low correlation. This helps minimize risk and make the portfolio more stable. Professional help can also be sought to make better investment decisions.
• Over-diversification: When too many investments are made and it affects the chances of getting high returns, then it is considered as overdiversification. Too many different investments in your portfolio can sometimes not be profitable over time. It also makes portfolio management difficult and costly. So, it is recommended to make a suitable number of investments to increase your chances of earning profits.
• Liquidity Needs: If you need to quickly convert your investments to cash, then it becomes important to consider the kind of asset you invest in. Some assets, like real estate and private equity, have long lock-in periods and are less liquid. It is better to keep some liquid assets to use in financial emergencies without using long-term investments.
• Time: It is important to plan the time for which you want to invest. If you are making long-term investments, then they can handle more risk and market volatility. But if you want an early exit, then it would be better to choose safer investment options like fixed deposit or a money market fund.
• Tax: Before investing in different assets, it is important to learn about the tax implications of those assets. Different assets have varied tax classes that can affect net returns, so make tax-efficient investment strategies to maximize after-tax gains.

Portfolio diversification is a method for reducing risks and increasing returns in the financial market. By putting your investment in different asset classes, geographical regions, sectors, etc., you can make a balanced portfolio. Regular balancing of the portfolio can also help lower the risks due to market fluctuations.  

By building and managing a well-diversified portfolio, investors can improve their long-term results and reduce the impact of market ups and downs.