What is diversification of portfolio and how to create it?
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.
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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Diversification of portfolio