How to Best Diversify? A Guide to diversification

  • Posted By :
  • Friday Mar 02, 2018

Key Takeaways

  • Short-term investments (Banks FDs) are the least risked profiles that safeguard money
  • Commodities signify investing in real estate or gold (Gold ETF) that help hedge against growing inflation
  • International stocks augment an investor’s buying capacity
  • Cash comes in handy during an emergency and needed as one grows older owing to added liabilities
  • Bonds (investments in government securities or corporate funds) are instruments that help in maintaining a regular income
  • When picking stocks or bonds for portfolios, choose those that perform against each other
  • Never bet major or entire corpus over a single fund

It is exasperating to time the market or economy, let alone beat it. Its impulsive temperament is impossible to punch and those who have tried doing so with no direction have often landed up frenzied. And it is not just tales of ambitious or new investors; even the most seasoned ones have to some point been caught-up in this inescapable swivel while trying to create wealth.

These days there are many ways to sensibly work with volatility, one of the most powerful element being, diversification. As simply put by Merton Miller, “Diversification is your buddy”. It is a rational mix of investments that helps balance out risks. Investments can be made in equity, bonds, commodities or real-estate funds.

Portfolio Building

Executing diversification starts with clever portfolio building. This is your foundation structure which will characterise your returns entirely. Focus more on variation than trying to just size-up the portfolio.

A portfolio should be in line with three central principles:

  • Time goals
  • Risk outlook
  • Current financial position

How to diversify based on investor categories?

Traditional Investor

If you are among those who covet to be conservatively established and create wealth in a more routine manner with little risk, you are a traditional investor. Build a portfolio like so:

  • 50% stocks (Indian equity)
  • 20% bonds
  • 15% Commodities (real-estate or gold funds)
  • 15% cash/short term investments

Unbiased Investor

This is your crowd if your approach is more balanced and fairly averse to risks.

  • Invest around 60% of your corpus towards equity (including international securities) and distribute the rest amongst other assets
  • Ambitious Investor

When referred to as ambitious, it means you have a higher risk appetitive and are willing to bet on more volatile (yet, potentially rewarding) instrument like Equity. You can structure your portfolio in the following manner:

  • 70% Stocks (indian and international equity in 50%-20% ratio)
  • 20% towards bonds
  • 10% towards other assets

Evolved Investor

You recognise the market; you have been in it and experienced it. You are the highest risk-taker and can work remarkably well with equity. For you, understanding of the global economy is uncomplicated and you have an acute knowledge of foreign securities. If you say yes, you are an evolved investor and can define your portfolio with over 80% in equity and the remaining 20% in other assets.

How to diversify based on risk classification?

1. Market Risk

This is associated with macro economic factors like inflation, balance of payment, gross domestic product, etc. These risks are unavoidable and it is significant that an investor understands them before investing in financial securities. Even low risk-bearing debt securities are subject to inflation.

2. Sector Risk

There are certain sectors like cement, auto, metal that are riskier than others. If the economy slows down, these sectors are most likely to be negatively affected and you are likely to witness major fall in profits. To minimise this, one should invest across sectors.

3. Security Risk

These are fundamental (company) level risks that depend on a stock’s market shares, financial strength, liquidity and profitability. To diversify securities-specific risk, an investor should invest in various well-managed stocks. 

4. Currency and Country Risk

These are specific to global investors and to diversify this, one should invest across geography (different countries).

5. Rebalancing and Over-Diversification

If an asset is representing a very small fraction of your portfolio, you are a victim of over-diversification. Furthermore, this clutters your portfolio which becomes extremely difficult to manage and rebalancing can get awfully confusing. An ideal portfolio must consist not more than 15-30 quality investments spread across industries.

Investments are dependent on returns that are the end products of a constantly shifting economy therefore revisiting becomes essential. Besides, this way you are more involved in your investments.

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