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How Portfolio Diversification Benefits You In Optimizing Returns



Portfolio Diversification Benefits

If you want to build a robust stock investment portfolio for your future. Then you must understand the concept of portfolio diversification. Portfolio diversification is the key aspect of portfolio management. And with proper portfolio diversification, you can optimize and safeguard your returns.

We have all heard the phrase – don’t put all your eggs in the same basket. This is most applicable to your investment. Portfolio diversification suggests you the same in the case of stock market investments. If done right, your stock market investment could rain money for you. So, being an investor let’s understand the concept of portfolio diversification, its benefits and Do’s and Dont’s.

1. Benefits Of Portfolio Diversification

A. Portfolio Diversification Minimises Risks

In case one of your eggs goes bad or in terms of investing – doesn’t perform well over a certain spell of time, your other eggs may hatch better. Doing so, you have assured at least one omelet or boiled egg. As similar to this example if one of your investment turns negative or performs poorly in the certain time span then other investment may help you to cap these losses or survive in such a situation.

B. Portfolio Diversification Helps You In Preserving Capital

Depending on which phase of life you are in, financially you would either be in accumulation or preservation of capital mode. Generally, HNI’s and people close to their retirement are focused more on the preservation of their capital. By diversifying you can protect your savings.

C. Portfolio Diversification Helps In Generating Returns

Remember all those heist movies where even after meticulous and foolproof planning the thieves/heisters still get caught. Investments too can go the same way. No matter how well you’ve planned/invested, there’s bound to be certain situations wherein your investment doesn’t perform as you expected. By diversifying you aren’t depended on a single source for income.

2. How To Diversify Your Portfolio

A. Set Up A Goal And Risk Return Profile

To diversify your portfolio you should first need to set up a goal. A financial goal for which you are investing your hard earned money. This may be a buying a dream house, children’s education, marriage or anything. At the same time, you need to understand your current responsibilities too. This helps you to understand your risk taking capacity.

Setting up a financial goal is just like getting ready for a long drive. Before taking charge steering of your car, you decide the destination. Then check fuel requirement and other important things like driving license and insurance documents etc.

B. Identify And Evaluate Different Asset Classes

Once you have defined your goal, you have decided your destination to travel. To reach the destination you need to explore the routes. As similar to that, for diversifying your portfolio you should evaluate different asset classes. With the analysis of various asset classes, you can understand the potential of each asset class. And also opportunities from these asset classes.

C. Explore Opportunities Within Asset Classes

After evaluating various asset classes, choosing the best-suited asset classes is the next important task. In a manner to diversify properly, you should shortlist the potential opportunities from your best-suited asset class. For example, if you are selecting from traditional investment classes, you can select FDs, RDs for a safer investment. From mutual funds, you may invest in debt funds, FMPs etc. And if you want to create an equity portfolio you can invest in large caps. Vice versa if you are an aggressive investor and can bear the higher risk, then you may invest in pure equity funds, midcap stocks, smallcap stocks etc.

In short, you need to explore all the possible opportunities from the asset classes suitable to your risk appetite.

D. Ensure Non-Correlation Of The Securities

After selecting the best securities from desired asset classes, you need to analyze the relationship between those securities. Its important to ensure the non-correlation of the securities from the portfolio. If the stocks or securities you have selected are correlated with each other, then it may hamper your returns. That is if the price of one security is hampered with other security then you may face dual losses. To avoid them you should understand the relationship between the stocks and sectors and pick your stocks wisely. Even for this a stock advisor or a PMS service stands out as a great option. As these experts, live, eat, breathe in the markets and are able to help you to pick the best stocks.

3. 5 Ways To Build A Diversified Portfolio

We understood the diversification as well as the importance of the diversification, but the question remains ahead is how one can build a diversified portfolio? Broadly there are five ways of doing it. Let’s explore these five forms of diversification that you should understand and include in your stock portfolio.

A. Company-level Portfolio Diversification

Individual company diversification is nothing but constructing a sound mix of the various stocks of the individual companies. It can be done with the proper research of the various stock from the various sector. The goal behind this diversification is to own the securities or stocks of the various companies to get benefited and earn profits.

B. Industry-Level Portfolio Diversification

Just like implementing a mix of individual companies, the industry diversification is also an important way to diversify your portfolio. As not only having a balance across the multiple different companies but also among industries in the economy is important too. It’s especially recommended to diversify away from the industries with which you are most familiar with.

For example, being a pharmacist or doctor one may have sound knowledge of the industry and its special features and potential but because of this overweighting pharma may cause a huge harm to the portfolio as any sudden happenings or any macro economical aspect like rupee depreciation occurs all the portfolio may turn red and play a spoilsport for your own hard earned money. The point is, just like with individual company stocks, it’s not healthy to favour and put extra money in a single industry that you are aware of.

C. Portfolio Diversification By Asset Class

Asset class diversification is something you can’t just consider in the case of a stock portfolio, it’s more relevant to the investment portfolio as a whole. There are different asset classes other than stocks like bonds, real estate, commodities etc. These asset classes perform differently in different economic conditions. For instance, during an economic recession, the debt securities like bonds safeguards the returns however in the economic recovery phase the equity investments turn out to be the performing gems.

D. Strategic Portfolio Diversification

The strategic diversification is useful in getting weighted exposure in various stocks and securities. There are strategies like the smart beta which replicates the indices in a weighted manner as well as there are strategies which are usually preferred by investors like growth strategy, value strategy, momentum strategy etc. However for implementing these strategies, one needs to get a professional advice as these strategies are closely related to the risk appetite of the investor. For most, the best approach to get best returns is a blend of these strategies with the realization of risk associated with every strategy and return potential from the various stocks.

E. Geographic Portfolio Diversification

Usually, investors prefer investing in stocks or securities in the domestic market. However, by following these investor face losses when the domestic markets fall with the macroeconomic concern. For example recently when INR that is Indian currency depreciated against the US Dollar then the US markets have performed a bit better than the Indian markets. If one has invested in the securities from the US market they may have managed to survive in bleeding markets.

4. Do’s and Dont’s of Portfolio Diversification

A. Always Keep An Eye on Current Asset Allocation

If you are an active investor then the first and most important aspect is to review the current asset allocation of your portfolio to understand where it stands currently and where you need to concentrate to optimize returns and diversification.

B. Always Consider Your Age

Your Age is one of the major influence rs for your portfolio. 100-minus age is one of the majorly used assets allocation strategy. Here your age is considered to analyze your risk appetite. The strategy defines that when you are at a younger stage of life you can take more risk, for example, the person with the age of 25 or 35 can allocate around 75 to 65% of assets in the equities.

C. Always Consider The Ability To Take Risk

The investor always needs to understand and consider the risk-taking capacity while investing in the equities. People with a steady income are able to take the higher risk as the market volatility won’t impact their monthly inflows thereby lifestyle. But this is won’t be possible with the investor who is retired or near to retirement. The basic need of such an investor is more likely to be the steady monthly inflows.

D. Don’t Think In Short Term, Think Long-Term

This is the specific rule for novice investors, many of the investor fall in this trap. They consider holding period as one year or less than that, however, to create wealth one need to stay invested for the longer term. Even if you see the historical performance of many stocks the one who held it for more than 3 years have bagged manifold returns. So when you diversify your portfolio, you should be determined about the time horizon for which you will be holding these stocks and plan accordingly.

E. Don’t Ignore The Other Asset Classes

Even though you are able to take a much higher risk and able to contain losses its quite risky to invest 100% of your corpus in equities. One needs to have emergency corpus as well which would be in hand and accessible. Therefore holding cash and other investments in asset classes like bank FDs, debt instruments, international equities etc could be beneficial to cap losses as well as it will play a role of plan B for you when you will face losses.

F. Don’t Over Diversify

Many investors tend to assume that higher diversification leads to better returns. According to modern theory, it has been considered as 15-20 stocks from different sectors are well enough to construct a diversified investment portfolio. The key purpose of diversification is to reduce risk, even if we see the correlation of bigger portfolios of mutual funds or any other ready-made portfolio we can see that post certain limit return capabilities are deterred. So its wise to have a balanced portfolio it should not be concentrated or over-diversified in both the cases returns and risks are hampered.

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