What is diversification of portfolio and how to create it?

What is diversification of portfolio and how to create it; How to diversify your investment portfolio

Overview – What is diversification of portfolio?
There are several investors who either loose the money or receive less returns when they invest their money in single class of investments. The success of the investment depends on how you diversify the investments. But what is diversification of portfolio?

What is diversification of portfolio?
Instead of putting all your money in one basket, invest your money in various asset classes to reduce your risk. This is called diversification of portfolio. If you are investing all your savings in stock markets, the investment is not diversified and all stock market flucatuations effect your investments which is high risk. But if you are investing your money in Stocks, mutual funds, Debt instruments, Gold etc., your investment is diversified.

Why diversification of portfolio?

In 2004, debt investments have given very low returns. Anyone who has invested heavily in debt instruments during that time has received very less returns.

In 2007, I invested some money in stock markets for Rs 2.2 lakhs apart from my real estate investment. Due to down trend in the market, my investment amount reduced to Rs 1 lakh. I have sold all my stocks even though I was incurring losses due to the personal emergencies.

The above are sample examples why we should not invest in single asset and should diversify.

Advantages of diversification of portfolio.
1)   Diversification of portfolio would help you to protect your money from various risks. Since you would not invest money in single asset class, your risk is diversified.

2)   It would help to increase your returns.

If you have invested in stock market which gave 15% annual returns in the last few years and also invested in mutual funds which gave 20% annualized returns in the last few years, your overall investment returns are 17.5%.

In the above  example, if you have invested in just a stock market, your returns would have been limited.

What is diversification of portfolio and how to create it; How to diversify your investment portfolio

Well, now how to create a good diversified portfolio:
There is no ideal portfolio. It depends on the risk appetite, the goals to be achieved, and period of investment.

Diversification of portfolio – explained with an example
Let us assume a person by name Sarath aged 30 years is married and has a kid. Now let us look at below sample portfolio where Sarath has invested Rs 500,000

1)   Investments in equity (Stocks and mutual funds) – 20%

2)   Investments in debt and fixed deposits – 60%

3)   Investments in gold – 15%

4)   Cash – 5%

If you see above example, below are the observations
1)   Sarath is at young age and he is heavily invested in debt and fixed deposits. He could increase his portfolio in equity for long term to enjoy the long term returns

2)   He is having a cash of Rs 25,000. In case he want any emergency cash of Rs 1 lakh it is very difficult

Now, how to modify the portfolio:
To continue the above example, Sarath can increase the portfolio size to say 40% to 60% in equity and another 20% in debt instruments. He can invest some money in fixed deposits which can be liquidated easily. Along with this, he can manage the cash which should total to Rs 1 lakh where he can use for any emergency. This is for sample purpose and this can be modified based on the investment objectives, goals and period of investment where one can wait.

Conclusion: Diversification of portfolio would help the investors to reduce the risks and increase the returns. However one should not do over diversification as it would be difficult to track. The objective of such diversification is to diversify risks, achieve the goals and invest for a specific period of time and get higher returns.

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Suresh
Diversification of portfolio

Article by Suresh

Suresh KP i.e. me have written 500+ articles on this blog. I love doing analysis and identifying the Best investment options.

8 Comments

  1. shiva says:

    Hi,Suresh
    I am 26 yrs old, earning 31k per month.I have a personal loan also of rupees 4lacs @ 16&. I have one LIC jivan surabhi money back policy (march -2010) & another is hdfc classic assurance (june-2013).i have to raise lump some money for sister’s marriage in next 2 yrs.i can invest 4k every month.which is best option,whether investing in SIP or in bank rd.i am confused.

    • Suresh says:

      Shiva, two observations 1) You are investing in insurance policies why ? Insurance is requird, but consider term insurance and invest balance in other investment options to get good returns. Any insurance products would give you between 4% to 5.5% returns only. 2) For short term of 2 years, my suggestion is to invest in bank RD or debt funds. If you want to take some risk, you can invest in debt funds like SBI Dynamic bond fund or IDFC Dynamic bond fund

  2. aparna says:

    Hi,

    I am 40 .  I want to start investment in SIP , mutual funds and Gold. I also have some amount  like  5-10  lakh that i want to invest .kindly design or suggest .

     

    • Suresh says:

      Hi Aparna, Invest in diversified and large cap funds such as HDFC Top-200, Birla SL Frontline, ICICI Pru focussed blue chip fund, UTI MNC Fund and debt funds like HDFC Prudence etc.,If you want to invest in Gold, you can invest thru gold ETFs like SBI Gold ETF and others. I would not advice you to invest lumpsum investment in them. You can choose bank FD or invest in 3 to 4 months period by splitting the amounts.

  3. finplanner says:

    I am 37 years old and married looking for financial planning for my future needs. Basically retirement,Child education.

    My current take home pay : 70,000

    Expenses : 40,000  

    Contigency fund :  in the form of FD available.

            Rental income from 2nd flat : 8000 

            Health insurance – Covered by Employer

             LIC policy : 5 lac SA in Money back/Jeevan anand policy

    current portfolio : 

    FLATS : 57% 

    FD : 19% 

    GOLD : 25% 

    Liablities – 0 .( Closed Home/Personal loan last month)

    Now all my investment avenues pure FD,GOLD and Real estate.  For diversification of portfolio and build corpus for Retirement,Child education , i would like to invest in MF SIP

    What will be the suitable portfolio for my case.

    • Suresh says:

      Hi, There are some gaps in your planning. If you have Rs 40,000 expenses per month, you need Rs 480,000 per annum and if we take conservative side, you need Rs 1 crore insurance. But you have insurance of Rs 5 lakh. In case of unforseen thing happening, your family would survive for 1 year. Have you not observed ? You should invest in large cap, diversified, balanced and debt mutual funds for retirement or for child education. Refer our top-10 mutual funds to choose and investing.

  4. Yuvaraj says:

    Hi Suresh,

    I am yuvaraj 29 age, having 1 daughter and my current salary is 38,000 PM. I planned invest for My daughter education, Marriage and my reteirment. My current Saving portfolio is

    a) HDFC Classic Assure Term Plan – 50,000 PM; b) LIC Endowsment Plan – 9700 PA; c) Recurring Deposit(3 Years) – 2500 PM in SBI; d) DSP Blackrock Top 100 Growth – 1000 PM (SIP); And I planned to invest in Following; a) E-Gold – 4 gram for an Year; b)franklin templeton Tax shield – 1000 PM(SIP); c) Planned to buy direct Shares for Long Term with in 6 months; 1) Yes Bank(20 Shares), ITC(100 Shares), Cipla(20 Shares); Please guide me , whether may portfolio looks good or i need to chage. I am new for investment.

    • Suresh says:

      Insurance policies difficult to confirm as they come with riders, terms and conditions. I reviewed other investment options. RD rates in SBI are good. DSP Top-100 is average MF, FD’s are better. Regd your query about e-gold, where are you investing. Why don’t you invest thru gold ETF’s as the charges are low comparing to gold mutual funds. Franklin tax shield is good one. Shares are also good. You can take some more tips from large cap mutual funds I suggested and top-10 SIP mutual funds I adviced in my articles.

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