2020 has been a tumultuous year, the year witnessed a lot of firsts. And the market crashed by thousands. Thankfully the phase was short-lived and the stocks surged back. While we are familiar with the volatility and unpredictability of Dalal Street, one of the key learnings of 2020 was realising the importance of portfolio diversification which is crucial for maximising gains. But, how to diversify your assets?
Most people dread the thought of risking their hard-earned money, and instead prefer to park their savings in traditional methods like bank fixed deposits (FDs). For them, it is important to understand one of the most basic and effective risk management techniques, i.e., diversification. Though, many of you must be familiar with it as well.
Asset allocation involves dividing an investment portfolio into options like stocks, bonds and cash. The process of determining a mix of assets for your portfolio might vary for different persons. This could call for investing 50% of one’s portfolio in equity and the rest 50% in debt. Another preferred way of asset allocation could be investing 25% one’s portfolio in equity, debt, real estate, and gold each.
What is diversification in investing
Suppose, you have a portfolio that only has airline stocks. The share prices will drop following news of an indefinite pilot strike. This means your portfolio will experience a drop in value. Now you can counterbalance these stocks with a few railway stocks, and only a part of your portfolio will be affected.
You could diversify the portfolio even further because of the risks associated with a particular sector. For example, if air travel is affected due to some reason, it will hurt both aviation and rail stocks, because they have a strong correlation. This means you should diversify your portfolio across different industries and companies. The more uncorrelated your stocks are, the better it is from an investment point of view.
Which assets should one seek to invest in?
Some financial advisors will ask investors to stick to equity and debt funds. Others will recommend that allocation be made to real estate, gold, and international equity, in addition to equity and debt funds. Bitcoin is an emerging asset too. Some of the leading stocks in Nasdaq 100, Dow 30 and S&P 500 may also be added for further diversification.
Diversification is important from a growth perspective. In a falling FDs and savings deposit rates scenario, investors need to look away to alternatives which can beat inflation and strengthen their portfolio.
What is diversification?
Diversification is a technique that reduces risk by allocating investments across various financial instruments so that your exposure to any one type of asset is limited. The purpose is to maximise returns by investing in different areas and help reduce the volatility of a portfolio.
Asset vs diversification
Investors tend to use the terms interchangeably. Asset allocation is the process of determining the right mix of investments you should own. On the other hand, diversification is what you invest in within these asset classes.
Diversification ensures that your money is never concentrated in the worst-performing assets. Successful market timing can make you a prudent investor.