Portfolio Diversification

Portfolio diversity means reducing investment risk by spreading investments across different asset types, which perform differently over time. This strategy mitigates risk and prepares you for future market changes.
Portfolio Diversification
4 mins
10-June-2024

Portfolio diversification is the process of spreading your investments across different asset classes, sectors, regions, and strategies to reduce your exposure to any single risk factor. By diversifying your portfolio, you can lower the volatility of your returns, enhance your long-term performance, and achieve your financial goals.

Read on to understand what is portfolio diversification, major types of portfolio diversification, examples, strategies, methods, objectives and more.

What is portfolio diversification?

Portfolio diversification entails distributing your investment funds among a range of assets or securities within your portfolio. Its objective is to mitigate risk and enhance the probability of attaining steady and reliable returns over time.

The fundamental concept of portfolio diversification rests on the premise that distinct assets carry different levels of risk and potential returns. Through maintaining a blend of assets with minimal or inversely correlated price movements, favorable performance in certain assets can counterbalance adverse performance in others amidst market fluctuations.

Examples of portfolio diversification

  • If you have a portfolio of only Indian stocks, you can diversify it by adding some international stocks, such as US, European, or Asian stocks, to gain exposure to different markets and currencies.
  • If you have a portfolio of only equity mutual funds, you can diversify it by adding some debt mutual funds, such as liquid, short-term, or dynamic bond funds, to balance your risk and return profile.
  • If you have a portfolio of only large-cap stocks, you can diversify it by adding some mid-cap and small-cap stocks, which may offer higher growth potential, but also higher volatility.

How to diversify your portfolio

  • Asset allocation: Asset allocation is the process of deciding how much of your portfolio to invest in different asset classes, such as stocks, bonds, cash, gold, real estate, etc. Asset allocation depends on your risk tolerance, time horizon, and financial objectives. You can use a simple rule of thumb, such as 100 minus your age, to determine your ideal stock-bond mix, or use a more sophisticated approach, such as the modern portfolio theory, to optimise your portfolio’s risk-return trade-off.
  • Rebalancing: Rebalancing is the process of adjusting your portfolio’s asset allocation periodically to maintain your desired risk level and target returns. Rebalancing can help you avoid overexposure to any asset class that has performed well or underexposure to any asset class that has performed poorly. You can rebalance your portfolio manually, such as once a year, or automatically, such as using a robo-advisor or a target-date fund.

Methods of portfolio diversification

  • Direct investing: Direct investing is the method of buying and selling individual securities, such as stocks and bonds, directly from the market. Direct investing can give you more control and flexibility over your portfolio, but also requires more time, research, and expertise. You also need to pay brokerage fees, taxes, and other transaction costs.
  • Indirect investing: Indirect investing is the method of buying and selling pooled funds, such as mutual funds, exchange-traded funds (ETFs), or index funds, that invest in a basket of securities that track a specific theme, sector, or index. Indirect investing can give you more diversification and convenience, but also involves management fees, expense ratios, and tracking errors. You also need to choose the right fund that suits your risk appetite and investment objective.

Objectives of portfolio diversification

  • Risk reduction: Risk reduction is the objective of lowering the overall risk of your portfolio by reducing the impact of any single risk factor, such as market risk, sector risk, currency risk, etc. By diversifying your portfolio, you can reduce the fluctuations of your portfolio’s value and protect your capital from unexpected losses.
  • Return enhancement: Return enhancement is the objective of increasing the overall return of your portfolio by capturing the opportunities of different asset classes, sectors, regions, and strategies. By diversifying your portfolio, you can benefit from the growth potential and income generation of various investments and achieve your financial goals.

Benefits of portfolio diversification

Listed below are some benefits of portfolio diversification:

  • Improved performance: Portfolio diversification can improve your portfolio’s performance by reducing the volatility of your returns and increasing your risk-adjusted returns. By investing in a diversified portfolio, you can avoid putting all your eggs in one basket and enjoy the benefits of compounding over time.
  • Reduced stress: Portfolio diversification can reduce your stress by lowering the emotional impact of market fluctuations and enhancing your confidence and peace of mind. By investing in a diversified portfolio, you can avoid chasing the market highs and lows and stick to your long-term plan.
  • Risk mitigation: Diversification serves as a primary method for reducing overall portfolio risk. By dispersing investments across various asset classes and securities, the impact of poor performance in any single investment on the entire portfolio is lessened, thereby avoiding overreliance on a single asset.
  • Stable returns: Diversification promotes more consistent and stable returns over time. While some investments may experience fluctuations or downturns, others may perform well, effectively balancing the overall portfolio performance.
  • Enhanced risk-adjusted returns: A diversified portfolio may yield superior risk-adjusted returns, delivering higher returns for a given level of risk compared to a non-diversified portfolio.
  • Access to diverse opportunities: Different assets and sectors respond differently to market conditions. Diversification enables investors to participate in various investment opportunities, potentially capturing gains across different market environments.
  • Hedging against volatility: During periods of market turbulence or economic uncertainty, certain assets may act as safe havens, cushioning the overall portfolio when other riskier assets decline in value.
  • Long-term wealth accumulation: Diversification contributes to long-term wealth growth. By spreading investments across different assets and avoiding over-concentration in a single investment, investors can benefit from compounded returns over time.
  • Tailored to objectives and risk appetite: Diversification allows investors to customize their portfolios to align with their specific financial goals and risk tolerance. A well-diversified portfolio can address short-term liquidity needs and long-term objectives, such as retirement planning.
  • Emotional stability: Diversification helps investors avoid making impulsive decisions driven by short-term market fluctuations. In the event of underperforming investments, a diversified portfolio is less likely to evoke panic and precipitate rash decisions.
  • Adaptation to market changes: Diversification enables the portfolio to adjust to evolving market conditions and economic cycles. Different assets may respond differently to shifts in interest rates, inflation, or geopolitical events.
  • Cost efficiency: Maintaining a diversified portfolio can help manage transaction costs and fees, as investors are not compelled to frequently buy and sell assets due to overexposure in a particular asset class.

Limitations of portfolio diversification

  • Diminishing returns: Portfolio diversification can have diminishing returns after a certain point, as adding more securities or funds may not significantly reduce your portfolio’s risk or increase your portfolio’s return. According to some studies, you can achieve optimal diversification by investing in 15 to 20 stocks or 5 to 10 funds, depending on your risk tolerance and investment objective.
  • Increased complexity: Portfolio diversification can increase the complexity of your portfolio by making it harder to monitor, manage, and rebalance your portfolio. By investing in a diversified portfolio, you need to keep track of the performance, fees, taxes, and risks of various securities and funds, and make timely adjustments to your portfolio.

How to diversify your portfolio with multi-asset allocation funds

One of the ways to diversify your portfolio is to invest in multi-asset allocation funds, which are mutual funds that invest in a mix of different asset classes, such as equity, debt, gold, etc. Here’s how you can go about it:

  • Multi-asset allocation funds can be a good option for investors who want to diversify their portfolio across different asset classes, but do not have the time, knowledge, or resources to do it themselves. Multi-asset allocation funds can offer a balanced risk-return profile, as they can adjust their asset allocation dynamically based on the market conditions and the fund manager’s outlook.
  • Before investing in multi-asset allocation funds, you should consult a financial advisor who can help you understand your risk profile, investment horizon, and financial goals, and suggest the best multi-asset allocation fund that suits your needs. A financial advisor can also help you review your portfolio periodically and make necessary changes to your asset allocation.
  • Multi-asset allocation funds can be a good option for investors who want to invest in a structured manner, such as through a systematic investment plan (SIP) or a systematic transfer plan (STP). SIP is a method of investing a fixed amount regularly in a mutual fund, while STP is a method of transferring a fixed amount from one mutual fund to another. Both SIP and STP can help you benefit from rupee cost averaging, which is the process of buying more units when the prices are low and less units when the prices are high, and reduce the impact of market volatility.
  • Multi-asset allocation funds can also work for investors who want to build their portfolio with the aim of long-term wealth creation, as they can offer consistent returns over different market cycles and reduce the risk of timing the market. Multi-asset allocation funds can also help you achieve your financial goals, such as retirement, education, or marriage, by providing a diversified and stable source of income and growth.
  • Finally, multi-asset allocation funds can be a financial fit for investors who want to follow strategic asset allocation to build a good portfolio, which is the process of deciding the optimal mix of asset classes for your portfolio based on your risk tolerance, time horizon, and expected returns. Multi-asset allocation funds can help you maintain your desired asset allocation without the hassle of rebalancing your portfolio yourself, as they can do it for you automatically and efficiently.

How to diversify your portfolio with hybrid mutual funds

  1. Understand your investment goals: Define your investment objectives, risk tolerance, and time horizon before selecting hybrid mutual funds to diversify your portfolio.
  2. Assess fund types: Explore different types of hybrid mutual funds, such as aggressive hybrid funds, conservative hybrid funds, and balanced hybrid funds. Each type offers varying levels of exposure to equities and debt instruments, catering to different risk profiles.
  3. Allocate across asset classes: Allocate your investments across different asset classes within hybrid funds to spread risk. Equity exposure can offer growth potential, while debt exposure can provide stability and income.
  4. Consider fund managers' expertise: Research and evaluate the track record and expertise of fund managers managing the hybrid funds you are considering. Experienced and skilled managers can navigate market fluctuations effectively.
  5. Review fund holdings: Review the underlying holdings of hybrid mutual funds to ensure they align with your investment objectives and risk appetite. Understand the fund's asset allocation strategy and its potential impact on returns.
  6. Monitor portfolio performance: Regularly monitor the performance of your hybrid mutual fund portfolio and rebalance if necessary to maintain your desired asset allocation. Stay informed about market trends and economic developments that may affect your investments.
  7. Diversify across fund houses: Consider diversifying across fund houses to mitigate the risk associated with individual fund houses. Invest in hybrid funds offered by different fund houses to spread counterparty risk.
  8. Stay updated with tax implications: Understand the tax implications associated with hybrid mutual funds, including capital gains tax and dividend distribution tax. Stay updated with tax laws and regulations to optimise your tax liabilities.
  9. Seek professional advice if needed: If you're uncertain about constructing a diversified mutual fund portfolio, consider seeking advice from financial advisors or investment professionals. They can offer personalised recommendations based on your financial goals and risk tolerance.

Points to consider while diversifying a portfolio

Here are some points to consider while diversifying your portfolio:

Factor

Description

Investment goals & risk tolerance

Define your financial objectives (retirement, down payment) and how much risk you're comfortable with.

Asset correlation

Choose assets with low correlation (opposite price movements) to minimize overall risk.

Number of Holdings

Aim for a balance: too few limits diversification, too many increase complexity.

Asset allocation

Decide the weight of each asset class (stocks, bonds) based on your risk tolerance and goals.

Rebalancing

Regularly adjust your portfolio to maintain the target asset allocation as markets fluctuate.

Research & due diligence

Analyze each investment's fundamentals, risks, and historical performance.

Costs & fees

Minimize expenses like management fees and transaction costs that eat into your returns.

Stay informed

Keep up-to-date on economic trends, market conditions, and events that could impact your investments.

Avoid overlapping investments

Review your portfolio to identify holdings with similar underlying assets, avoiding unintended concentration.

Avoid emotional decisions

Stick to your long-term plan and don't react impulsively to short-term market movements.

Tax implications

Understand how taxes affect your investments. Different assets may have varying tax treatments.

Assess performance

Regularly evaluate your portfolio's performance against your goals and adjust as needed, but avoid chasing short-term gains.

Diversify across time

Consider dollar-cost averaging by investing a fixed amount periodically to reduce the impact of market volatility.

Conclusion

Portfolio diversification is an important concept for investors who want to reduce their portfolio’s risk, enhance their portfolio’s return, and achieve their financial goals. It can be done in different ways, such as by investing in different asset classes, and by using different methods.

However, portfolio diversification also has some limitations, such as diminishing returns and increased complexity. Therefore, you should consult a financial advisor to review your portfolio periodically to make necessary adjustments.

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Frequently asked questions

How does portfolio diversification reduce risk?

Portfolio diversification reduces risk by investing in different assets that are not correlated, so that losses in one asset can be offset by gains in another.

How do banks encourage portfolio diversification?

Banks encourage portfolio diversification by offering various products and services, such as mutual funds, bonds, fixed deposits, gold, and real estate, that cater to different risk profiles and investment goals.

What are some common mistakes to avoid in portfolio diversification?

Some common mistakes to avoid in portfolio diversification are:

  • Over-diversifying or under-diversifying your portfolio
  • Ignoring the costs and fees associated with diversification
  • Not rebalancing your portfolio periodically
  • Not diversifying across geographies and sectors
  • Not considering your time horizon and risk tolerance
What does diversification mean?

Diversification refers to spreading investments across various assets to reduce risk. It involves allocating capital into different types of assets, such as stocks, bonds, and real estate, to minimise the impact of adverse events on the overall portfolio.

What is the best example of portfolio diversification?

A well-diversified portfolio might include a mix of stocks, bonds, real estate, and cash. For instance, owning shares in different industries, geographic regions, and asset classes can help mitigate the risk associated with any single investment.

What is the diversification rule for mutual funds?

The diversification rule for mutual funds typically involves investing in a variety of securities within the fund to spread risk. Mutual funds often have guidelines regarding the maximum percentage of assets that can be invested in any single security to ensure diversification.

How do you diversify a fund portfolio?

Diversifying a fund portfolio involves selecting a mix of assets with different risk-return profiles. This can include investing in various sectors, industries, geographic regions, and asset classes to spread risk and potentially enhance returns.

What is the 25% diversification rule for mutual funds?

The 25% diversification rule for mutual funds suggests that no more than 25% of the fund's assets should be invested in a single security. This helps ensure that the fund is adequately diversified and not overly reliant on the performance of any individual investment.

What is the 5% rule of diversification?

The 5% rule of diversification suggests that no single investment should represent more than 5% of an investor's total portfolio value. This rule helps prevent overexposure to any single asset and promotes diversification.

Is it good to diversify mutual funds?

Yes, diversifying mutual funds is generally advisable as it helps spread risk across various investments, potentially reducing the impact of poor performance in any one asset. Diversification can help investors achieve more stable and consistent returns over time.

What is the best diversified portfolio?

The best diversified portfolio typically consists of a mix of assets from different classes, such as stocks, bonds, real estate, and commodities. The ideal allocation varies based on individual goals, risk tolerance, and time horizon, aiming to minimise risk while maximising returns through exposure to various market sectors.

What is the biggest benefit of portfolio diversification?

The biggest benefit of portfolio diversification is risk reduction. By spreading investments across different asset classes, industries, and regions, diversification helps mitigate the impact of market volatility on overall portfolio performance. This approach can enhance long-term stability and potentially improve risk-adjusted returns.

How is portfolio diversity calculated?

Portfolio diversity is calculated by assessing the distribution of assets within a portfolio. One common method is to measure the correlation between the returns of different assets. A diversified portfolio will have assets with low correlations, meaning they move independently of each other. Additionally, diversification considers the allocation of assets across various sectors, geographies, and investment types.

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Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

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