Global capital markets, and the spectacular returns that they have generated for investors over the long run, are notorious for acting like a flower to bees (market participants) worldwide.
However, we must not forget that market returns are an independent variable that no one has control over. The only controllable factor for any market participant is “Risk” or “exposure.” However, most often, in the blind chase of returns, we forget to manage our risks, which results in disastrous outcomes. In this article, we discuss an essential tool of risk management; DIVERSIFICATION.
Grandma always told us not to put all our eggs in one basket. This principle is very relevant in investing. Here, the eggs can be the securities we invest in, and the basket refers to a particular asset class, sector, or theme.
By splitting our eggs over several baskets, we avoid bearing significant losses if a single slip falls out of our hand, meaning if a particular asset class or sector suffers huge negative moves.
Let’s discuss some benefits of diversification!
Assists in mitigating the impact of market volatility
A diversified portfolio reduces the portfolio’s total risk. Due to the diversification of investment across asset classes and sectors, the overall impact of market volatility is mitigated. By diversifying investments among funds, industry- and enterprise-specific risks are minimized. As a result, it mitigates risk and delivers superior returns over time.
Decreases the amount of time spent monitoring the portfolio
A diverse portfolio is more stable than a concentrated one, as not all investments perform poorly concurrently. Investing your entire portfolio in just one asset class, say equity shares, for example, means that a lot of your time and attention will be spent on determining the following best action in the market because all your eggs are in the same basket (equities). Similarly, if you invest only in low-risk, low-return debt instruments, a lot of your time and effort would be devoted to trying to boost your returns. Therefore, diversification allows you to strike an optimal balance between risk and return, allowing you to focus on other core competencies like work, business, etc.
Contributes to the accomplishment of long-term investment goals
Most people invest to accomplish specific life goals. These goals can be dynamic and hence, require an agile and adaptable investment approach to be achieved. Diversification helps investors achieve their goals. For instance, say an investor has three primary life goals:
1) Son’s education in 7 years
2) Foreign vacation every year for the next ten years
3) Accumulate a large corpus for retirement 15 years for now
In this case, 100% allocation towards equity or debt would not be sufficient in achieving the goals. Hence, an ideal mix of the two or even other alternative investments would be required to match the investor’s goals.
Assists in obtaining the benefit of compounding interest
Portfolio diversification (most times) helps by minimizing portfolio drawdowns in times of duress in capital markets. By doing so, it ensures that infrequent but significant negative moves do not dent your investment returns over the long term and hence allows your wealth to enjoy the joys of compounding over long periods.
Contributes to the capital’s security
Not all investors are risk lovers. Investors approaching retirement age or those who are new to investment may seek stability in their portfolios. Diversification across asset classes or various securities within asset classes can provide this stability and help such risk-averse investors protect their wealth against market volatility.
Allows you to swap between investments
Diversification is a prudent strategy that every investor should employ. It enables investors to rebalance their portfolios and profit from market volatility. It enables investors to diversify their holdings among asset types, hence increasing annual returns.
A common strategy that many investors have successfully applied is gradually increasing allocation towards debt after periods of excellent equity performance and increasing allocation towards equity during sudden equity market crashes/underperformance.
Peace of Mind
The most significant benefit of diversification is peace of mind. When an investor’s overall investment is spread among multiple asset classes, they will not be concerned about the portfolio’s performance on a short-term basis vs when all his investments are concentrated in a single asset class.
To conclude, diversification is a handy risk management technique that can help investors protect themselves against significant losses due to concentrated bets and allows one to strike a balance between risk and return. Each of us must allocate % of our portfolio to different asset classes or securities based on our goals and ambitions while considering our short-term cash-flow positions. And always remember: it’s never a good idea to put all our eggs in one basket!
Also, diversification may aid an investor in risk management by lowering the volatility of an asset’s price changes. However, you must remember that no matter how well diversified your portfolio is, risk can never be avoided.
You can mitigate risk associated with specific stocks, but market hazards touch practically every stock, so diversification across asset classes is critical. The secret is to maintain a balance between risk and reward; this allows you to accomplish your financial goals while still obtaining a good night’s sleep.
