What is Portfolio Diversification?

Portfolio diversification is an important concept for investors who want to reduce their portfolio’s risk while enhancing returns.
Portfolio Diversification
4 mins
04 Feb 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.

2 Major Types of portfolio diversification

There are many ways to diversify your portfolio, but some of the common ones are:

  • Stocks: Stocks are shares of ownership in a company that trade on a stock exchange. Stocks can offer high returns, but also carry high risks. You can diversify your stock portfolio by investing in different industries, market capitalizations, growth and value styles, and geographies.
  • Bonds: Bonds are debt instruments that pay a fixed or variable interest rate to the lender. Bonds can provide steady income, but also have interest rate and credit risks. You can diversify your bond portfolio by investing in different types of bonds, such as treasury, corporate, municipal, and international bonds, with different maturities, ratings, and yields.

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.

Strategies for portfolio diversification

  • 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

  • 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.

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.

Tips to diversify your mutual fund 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.

Diversifying your mutual fund portfolio with hybrid mutual funds can enhance your investment strategy. Here are some tips to consider

  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.

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.

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
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