One commonly used phrase in investing is ‘Don’t put all the eggs in one basket’. This means you have to spread your investments across asset classes and securities to reduce the risk of investing. This is known as diversification. It is a risk management technique used to reduce the downside risk in a portfolio and increase long-term returns.
What is Portfolio Diversification?
Diversification or portfolio diversification is a strategy that attempts to reduce the risk in a portfolio by spreading the investments across a wide variety of investments and asset classes. The basic idea behind investing across different investments is to reduce the downside risk and increase returns in the long term. However, it is important to note that diversification doesn’t guarantee returns, it only aims to mitigate the risk in investing.
Diversification is done by spreading the investment across asset classes, instruments, industries, and geographies. In the case of asset classes, you can invest in equities, debt, gold, and real estate. With respect to diversification across instruments, there are shares, mutual funds, government securities, bonds, etc. You can also diversify by investing in securities across different industries and geographies.
How Does Portfolio Diversification Help Reduce Risk in Investing?
- Offsets losses: With multiple asset classes in a portfolio, you are offsetting the losses of one asset class with profits from another asset class. This way, you are reducing the risk of a drastic loss in your portfolio.
- Hedging: By spreading your investments across instruments, asset classes, and geographies, you are less vulnerable to specific risks. For example, if you invest in debt securities of a company and it defaults on the payment, you have other securities in your portfolio to maintain the overall portfolio return. Imagine investing your entire money in the debt securities of this company. You would end up losing all your money. Since you diversified your investments, the returns from other securities are not affected.
- Reduces volatility: Since you invest in multiple asset classes, you have a portfolio of investments that have a low correlation to one another. This reduces the volatility and risk in the portfolio.
Different Types of Portfolio Diversification
There are different ways through which you can diversify your investment portfolio. Following are the different types of diversification.
1. Asset class diversification
The ideal way to build an investment portfolio is to invest in different asset classes. Different assets react differently to changing economic conditions. Many asset classes move in different directions in certain situations. Take, for example, gold and equity. They move in opposite directions in many situations. Some asset classes soar during an inflationary environment, while others perform poorly. Commodities, gold, and stocks of industries such as the healthcare industry and consumer staples benefit from inflation. In contrast, consumer discretionary and construction equipment industries were affected by inflation. Hence by adding different asset classes to your portfolio, you can reduce the risk of losses.
2. Industry diversification
The economy is made up of different industries, of which many are correlated, and many are not. Investing across industries will help maintain portfolio returns as losses of one industry are offset by the profits of another industry. This is because all industries move in cycles, and not all have similar cycles. In other words, when an industry is in the expansionary phase, the others might be in the contraction phase. Hence you must invest in different industries that are not correlated to ensure your portfolio is diverted.
3. Geographic diversification
The world has become a global village. Travelling, shopping, and even investing across nations have become easier than before. In a world filled with developed, developing, and emerging nations, there are several investment opportunities available to you. All you have to do is invest in securities across different nations to reduce the country and currency risk in your portfolio.
4. Strategy diversification
There are several investment strategies that are used by experts to build a portfolio. Some of them are growth, value, income, dividend, and contra strategies. You can use a mix of all these strategies and build a portfolio that can help you build long-term wealth and, at the same time, earn additional income in the short term.
5. Time diversification
When you spread your investments across different time horizons to minimize the risk of a period and maximize the return, you are using a time diversification strategy. Short-term day trading, buy and hold strategy, or rupee cost averaging through SIP is all time diversification strategy.
6. Alternative asset diversification
Investing in assets that aren’t mainstream such as art, antiques, private equity, hedge funds, venture capital, and distressed securities is alternative asset diversification. This strategy can be used when you have a very large corpus to invest.
7. Risk diversification
Different securities have different levels of risk. Investing across securities with varying levels of risk exposure reduces the total risk in a portfolio.
What is Risk Diversification?
As mentioned above, diversifying your portfolio across securities with different levels of risk is known as risk diversification. Investments have different kinds of risks, namely, systematic risks and unsystematic risks.
Systematic risks are market risks such as war, political conflict, interest rate changes, or stock market volatility. Systematic risks are difficult to reduce, but you can hedge them.
Unsystematic risks, on the other hand, are specific risks that affect one single industry or company. Investing across industries or companies can help you reduce the unsystematic risk in a portfolio.
What is Unsystematic Risk Diversification?
As mentioned above, you can reduce the unsystematic risk in your portfolio through diversification. Before we understand the strategies for risk diversification, we must know the different types of unsystematic risks.
Types of unsystematic risks
- Business risk: Both internal and external issues cause business risks. Internal issues such as labour shortages or labour strikes can lead to production delays which will ultimately affect the revenue and profits. On the other hand, external issues like the government banning the import of a few important raw materials can make it difficult for the company to produce goods at a low rate affecting profitability.
- Financial risk: The risk of losing money on an investment is financial risk. If a company invests in certain securities, a default by those securities can wipe out the entire investment of the company.
- Operational risk: Risks tied to the operations of the business are operational risks. Take, for example, exposure to confidential data of the company, or break down in the supply chain of a business, or a leak in the company’s gas tanks are all operational risks that can affect a business.
- Strategic risk: Risks evolving from delay in strategic decisions or making a wrong decision are strategic risks. For example, if a competitor uses the latest technology to produce goods to reduce its cost by half, and a company is still using old machinery, then it will lose out on those additional profits.
- Legal or regulatory risk: Laws and regulations that govern an industry keep changing. When the government suddenly changes these laws, it can affect the business. Take, for example, a ban on imports of certain goods or an increase in quality norms which will increase operational costs. All these will affect the business.
Strategies for risk diversification
The following strategies will help you reduce the unsystematic risk in a portfolio.
- Business risk: Both internal and external issues cause business risks. Internal issues such as labour shortages or labour strikes can lead to production delays which will ultimately affect the revenue and profits. On the other hand, external issues like the government banning the import of a few important raw materials can make it difficult for the company to produce goods at a low rate affecting profitability.
- Financial risk: The risk of losing money on an investment is financial risk. If a company invests in certain securities, a default by those securities can wipe out the entire investment of the company.
- Operational risk: Risks tied to the operations of the business are operational risks. Take, for example, exposure to confidential data of the company, or break down in the supply chain of a business, or a leak in the company’s gas tanks are all operational risks that can affect a business.
- Strategic risk: Risks evolving from delay in strategic decisions or making a wrong decision are strategic risks. For example, if a competitor uses the latest technology to produce goods to reduce its cost by half, and a company is still using old machinery, then it will lose out on those additional profits.
- Legal or regulatory risk: Laws and regulations that govern an industry keep changing. When the government suddenly changes these laws, it can affect the business. Take, for example, a ban on imports of certain goods or an increase in quality norms which will increase operational costs. All these will affect the business.
Pros and cons of Portfolio Diversification
Benefits of Diversification
- Protects your portfolio from risks: The primary advantage of diversification is that it protects your portfolio from risks. It reduces the downside risk in a portfolio by spreading the investments across different instruments and securities.
- Exposure to different sectors: Diversification will give you exposure to different industries. By investing in different industries, you can take advantage of an upcycle in an industry. Take, for example, the travel industry. Although it was almost dormant during Covid-19, right after the second wave, the industry experienced a sharp recovery owing to revenge travel. Had you invested in this industry during covid, you would be reaping a huge profit.
- Explore different investing strategies: In diversification, you can use different investment strategies such as growth, contra, or value investing. All these will help balance your portfolio and boost the portfolio returns in the long term.
- Tap foreign markets: Through diversification, you would be investing in foreign securities. By adding these securities to your portfolio, you can take advantage of the market boom in foreign countries as well and reduce the currency risk in your portfolio.
- Can lead to higher returns: Although diversification doesn’t guarantee returns, it can increase the overall portfolio return in the long term by reducing the chances of downside risk.
- Offers liquidity: By investing in both short-term and long-term securities, you can enjoy the benefits of long-term wealth and, at the same time, have enough liquid investments which will aid you in times of emergency.
- Provides relief: A diversified portfolio will help combat the market downturn, which ultimately will improve the portfolio return and help in fulfilling your financial goals. This offers a sense of relief and peace of mind to you.
Disadvantages of Diversification
Although diversification helps mitigate the risk of investing, it comes with some limitations.
- Higher risk of investing in wrong securities: With a plethora of investment options available in the market, you tend to get confused and might end up investing in the wrong securities. This is worse than not diversifying at all.
- Managing portfolios can get difficult: Each asset class has different rules and works differently. With so many investments in a portfolio, managing them can get difficult.
- Tax implications: Different securities have different tax implications. If you do not know the tax rules for them, you might end up paying more tax from your pocket. Or, if you hire a tax planner, you might have to pay their fees.
- High cost of investment: Every security has a certain fee and charge attached to it. Diversifying your investments across securities can increase the cost of investment, which can ultimately dilute your returns.
- Capping growth: Although diversification can reduce risk by spreading the investments across asset classes, you can lose out on high returns from a particular security or asset class when they grow.
Conclusion
Diversification is an excellent strategy to mitigate risk in a portfolio. This can also increase returns in the long term. However, over-diversifying can cause more harm than help and reduce the overall returns of the portfolio. Hence it is important to optimally diversify your portfolio to reduce the downside risk and maintain the portfolio returns.
Frequently Asked Questions
What is portfolio diversification?
Investing in multiple securities across asset classes, industries, and geographies is known as portfolio diversification. It is a risk management strategy used to reduce downside risk in a portfolio and maintain the overall portfolio return, which will ultimately lead to long-term wealth creation.
Why is diversification important?
Imagine a situation where you have only invested in the pharma industry. During Covid times, you must’ve gotten high returns as drug manufacturers gained from the pandemic. However, after the pandemic effect was reduced, pharma companies were hit badly. You would’ve lost all your gains in a few months. However, if you also invested in the travel industry and IT industry, you could have negated the losses of the pharma industry with profits from the travel and IT industry.
This is why diversification is important. Diversification helps reduce the risk in a portfolio, gives exposure to multiple asset classes and securities, and even offers higher returns in the long run. Without diversification, your portfolio will be highly vulnerable to risks, and you might end up losing all your money.
What is diversification of risk? Explain with an example.
If you invest 50% of your portfolio in equity, 20% in debt, 20% in gold, and 10% in cash, you have diversified your portfolio. In case the market falls, then the debt, gold and cash will negate the risk of equity in your portfolio. This is known as diversification of risk.
What is diversification and its types?
When you invest across different asset classes, industries, or geographies, you are diversifying your portfolio. There are several kinds of diversification, namely asset class, time, alternative asset, industry, geographical, and strategy. Using any of these can help you optimally diversify your portfolio.
- Asset class diversification
- Industry diversification
- Geographic diversification
- Strategy diversification
- Time diversification
- Alternative asset diversification
- Risk diversification
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