How to Diversify Your Portfolio

2019/02/25

Never put all your lemons in one basket is the saying that holds in almost every field. Diversification of type of troops helped emperors win war as well as diversification of the business types helped corporates to become moguls of the trade. It essentially means spreading your risks while optimizing your returns. Just like putting all the lemons in one basket has the risk of the basket being lost and with it the lemons, similarly the analogy is drawn in the investment scenario where you should not put all your money in one basket or instrument. The risk lies in that your money may get lost in the maze of the risk which often gets unnoticed by a layman.

In the current market place an investor is spoiled with choices when it comes to investing.
There are just N number of avenues to invest your money on; some having a huge potential of return while being risky and some less risky but yielding less return too. The tools of the trade actually balances itself here with respect to the risk and return of an instrument. Higher the risk you have, higher the return you gain is the often repeated phrase in most of the investment options available in the market.

It may look quite tempting in fact to put all your money in that instrument which is giving you the highest return over the last few years. In fact there would be instrument sellers guised as advisers queuing up to you explaining the past returns. What they may not tell you however is the risk attached with the expected returns in case some favorable scenarios turn turtle.

There are a plethora of instruments some less risky, some high risk which as I say may not be actually so transparent to be seen by the eyes of a layman. So what is to be done in such a case. where would i invest? The answer if you are scratching your head lies in the title of this article. Yes, Diversify your investments so that your money do not get tucked up in one type of instruments or options only.

By diversification what you have also achieved apart from spreading your risks is the benefit of an weighted average return. So instead of Equity A where you might have invested your X sum of money you have now diversified your amount in Equity A and B and a certain Debt option C. What happens here is even if one of them goes down on the market value there might still be a chance that the other ones hold up and averages your loss.

One golden rule of portfolio diversification is however to always keep note that the risk exposure factors of the instrument classes are not synchronous to each other. Once you have chosen Asynchronous assets in terms of risk factors you have your job over by 90%.  This actually ensures that your portfolio diversification works wonders when a particular asset class is going through a rough patch and returns are decelerating. The rough patch for one instrument may not be the same for another asset class or type which may in fact show signs of growth.  This would balance out your losses.

The exercise of spreading out your money in different asset or instrument types definitely helps in mitigating the risk associated with individual investments. Spreading the money across several securities or asset classes having little or no correlation to one another is the essence of diversification. What you achieve out here is that you have cut out the risk of a huge and significant loss in one asset type because of some under performance.

Instead of seeing the value of one asset plummeting day after day what you have achieved through diversification is that your capital is spread out across various asset types. So, even if one type under performs the other lemons having less correlation to the under performing one may actually over perform and thus you have cut out the negative impact that the under performing stock is bringing to your portfolio.

The fruits of diversification shows its true colors with respect to picking stocks in the equity market. A diligent research done on the stocks would help you pick up the securities on which you should be betting your money on. The research or study conducted on stocks should include the effect of parameters like Size, nature of work or the industry in which the company is in, govt regulations in place benefiting a particular stock and the order size in place.

Once the study is conducted you would have to make sure that your portfolio is not cluttered with stocks of the same type. Let me stress again this is the meaning of diversification. By picking up representatives from different sectors, sizes and behavioral entities what you essentially achieve is spreading out your risks. If the idea of doing a fundamental research seems a bit overdosed for you, there is my simple time tested solution for you. First make a list of 3 or 4 good performing stocks from different sectors like FMCG, construction, chemical etc.

Take your pick. Now check historically which one of them across sectors have behaved in the opposite directions, that is check when ones price was up whose price went down. If you have zeroed in on some of them you have got your candidates for your diversified portfolio. Now build up your portfolio and repeat this exercise again and again over the future time frame.

Again another debate with respect to  a portfolio diversification and which may arise in your mind is you are limiting your gains here. Truly the gains may be lesser than in the case of an investor who has done everything right, has timed the market, has invested in the highest return yielding instrument class and has booked his / her profits at the right time. But then how many times did you see him / her do everything right. Diversification helps when you do not have the acumen, time or attention to get everything right. It is like not putting all the lemons in one basket and being sure that at least some lemons would come back home if not more.

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