5 reasons why it is important to diversify your investment
Diversifying your portfolio is the market equivalent of not putting all your eggs in one basket. It reduces risk, and in case of an unlucky day, your entire portfolio does not come crashing down at once. Diversification is a concept all seasoned investors swear by. It is imperative to remember that not all kinds of investments perform well during the same period. Multiple kinds of investments are affected in various ways, affected by economic factors, world events and much more. It should be obvious that, putting your money behind a mixed bag of investments is a fail-proof idea.
You can diversify your investment by investing in a variety of asset classes and carefully choosing your mix of investments. Asset classes can be broadly categorised into equity, bonds, properties, commodities and cash. Diversified portfolios have exhibited lower risks and delivered greater returns over time. In order to diversify your portfolio, you should invest in a good mix of stocks apart from bonds and funds. Diversification is not a rule written in stone, but is a risk avoiding move. Imagine putting all your money into the stocks of one particular company – if the company sees a downfall, your investments will face the brunt of decline. Let’s dive into more detail.
A non-diversified profile can give you very extreme results, and more often than not, it could sway towards the negative in the longer run. For example, say you put all your money in the IT industry, the initial boom might give you enough confidence to carry on with this profile. However, if the sector crashes due to any problem like the dot-com did in 2000, you will be left with lesser wealth than you initially started with.
On the other hand, if you end up allocating your money and investing it in different sectors, the risks is reduced. For example, during the dot-com bubble, there were certain sectors which did make money and were able to evade losses. Retail giant Walmart saw a considerable jump in its stock valuation during this time. Similarly, comcast revenues also rose. Hence, if you did invest a fraction of your money in the stocks of these companies, the recession may not have hit you so hard.
The ideal way to diversify your profile is not just across different companies, but also across different industries and different asset classes. Bonds will not necessarily react to market situations as stocks will. Inclusion of several asset classes will reduce the sensitivity of your portfolio and may even offset the unpleasantness of the other during crucial market swings.
You can also divide your portfolio and invest in a mix of cyclical and non-cyclical stocks. Cyclical stocks include sectors which people readily invest in when the economy is strong. These could include those that provide items which are disposable, or which people can necessarily do without. Examples include apparel manufacturers or luxury goods. These stocks perform well when the economy is doing well, however, they take an indefinite hit when the economy is down. Non-cyclical stocks on the other hand are not affected by the ups and downs of the economy since their demands are not dictated by market trends. But there is a flip-side to these stocks.
When the market does very well, and cyclical stocks are booming, the non-cyclical stocks have a very plateaued performance. These are often considered ‘safety stocks’ and are a major diversifier in the portfolio. Water and electricity are examples of non-cyclical stocks.
Another way to diversify your portfolio is by including bonds. Bonds have low volatility and do not give extreme results. In fact, it is generally advised that, the older you are, the more you should invest in bonds. Stocks are highly volatile, and you may lose a lot of money at any time. With age, it is difficult to retrieve large amounts of lost money, hence at least 30% of your investments should be in bonds.
An example of portfolio diversification. (Image source: The college Investor)
In 2010, no-one would have given cryptocurrency a chance. However, for anyone who invested as much as $100 back then in Bitcoins, would be sitting on 28 million dollars’ worth of money. We’re not advocating that you jump onto the cryptocurrency bandwagon, but recognise that the market works in a very unpredictable manner, and occasionally you come across rare investing opportunities at the early stage that later take the world by storm.
Mutual funds are an ideal way to diversify your investments, since their model involves diversification by default. Mutual funds pool in funds from multiple investors and invest them across securities, or even different asset classes. Schemes from HDFC mutual fund are a good place to start investing. Its ‘Top 200’ scheme has consistently been a high performing fund, and they offer systematic investment plans as well.
Diversification cannot completely prevent losses. However, it can cushion the blow of any unforeseen or drastic changes on the market, or any frauds on your portfolio.