We have backups for most of the things that may go wrong. In case of a power outage, we have inverters and generators installed in our houses. In case of loss of critical data, we always back it up on the other computer. Not just data and power, we have backups for our lives. In case anything happens to us, we always have a life insurance policy as a backup. Backups are great diversification techniques that mitigate our risk against unforeseen events that may cause loss of data, power or life.
Diversification is a part of investment strategy where invested capital is spread in various assets or asset classes so that if one of the assets does not do well, your capital will be safe in other assets. Diversification is used by all financial institutions to mitigate their business risk. Banks diversify their risk by giving loans to many people instead of a few to diversify the risk of default. If someone is unable to pay back the debt, banks will not go bust and can overcome the losses. Similarly, Insurance companies insure many assets so that if one of the assets gets damaged and claims insurance coverage, the company will be able to pay them and won’t go bankrupt in the process.
Advantages of Diversification
An average investor can diversify his capital by spreading in different stocks or in different asset classes such as bonds, real estate, gold bank deposits. Diversification is not just limited to minimizing investment risk, it also has many other advantages such as:
Taking advantage of sectoral rally
When markets see a bull run, there are always some sectors that lead the rally, and all the other sectors follow. Stocks that belong to leading sector give highest return on investment. For example, if oil prices fall, companies that depend on oil as their raw material (such as paints chemical companies etc) get raw material at a lower price, which in turn improves their margin leading to rally in stock prices. If your portfolio is well diversified, part of your capital invested in these companies will see a huge gain, giving you better return on investment.
Prevention against crisis
Diversification of your portfolio also prevents you against risk of economic crisis. For example, when economies crash, assets like gold are seen as a safe heaven against economic crisis. In such a situation, your part of your investment in gold will mitigate the losses you suffer by investing in stocks. Such diversification acts like a safety net against the free falling market.
Tax saving
Diversification can also be a great way to save tax on profits earned. For example, money invested in stock market for more than one year is not taxed. Also, investments made in many government bonds, insurance schemes and mutual funds is also exempted from tax. A person looking to make good return on invest while saving tax can use these asset classes, and diversify his portfolio while pocketing some extra cash as tax savings.
Avoiding overexposure
Diversification also prevents overexposure of your portfolio in one sector or asset class, preventing a significant downside risk. If a major part of your invested capital is parked in one sector or asset class if that sector or asset performs negatively, your return on investments may take a big hit. For example, if majority of your capital is invested in bank deposits, and if central bank cuts interest rates significantly, your interest income will fall drastically, making it harder to achieve your financial goals. By diversifying your portfolio, you can prevent overexposure of your risk to an asset class, mitigating investment risk.
Providing liquidity
When professional financial planners diversify your portfolio, a part of your capital is invested highly liquid assets such as bank deposits, short term bonds. If you experience a financial emergency and need some money in a short period of time, money invested in these assets can be easily converted into cash, providing liquidity to the investor.
Diversification is all about spreading your capital to prevent investment risk. This does not mean that by simply throwing money in different assets, your investments will automatically become less risky. You need to diversify your investments by considering your purpose of investment, your income levels, risk appetite and investment time horizon. There are many levels of diversification and you need to take them into consideration before making an investment decision.
Levels of Diversification
There are three basic types of diversification that distribute your capital. These types are based on levels ranging from individual company to different asset classes.
Individual company diversification
This is the lowest level of diversification where invested capital is distributed in different stocks that belong to same sector. To do this, some of the best companies of the same sector are selected and money is invested in them based on their past performance and expected future growth. Higher weightage is given to the companies that have better performance compared to peers. Such diversification is used to take advantage of the expected growth in the sector, while mitigating risk of overexposure in a single stock.
Sectoral or industry diversification
The second level of diversification is sectoral or industry level diversification. It is not a healthy to be overweight on a single sector because if the sector suffers a slowdown, your investments will perform poorly. That is why it is important to distribute your invested capital in various sectors to take advantage of growth in other sectors. Sectoral diversification distributes your wealth in different sectors, when broader markets rally, almost all the sectors see a good growth. Diversifying your investments in different sectors gives you dual benefit of de-risking your investment by spreading it across the sectors and by taking advantage of overall growth in the overall market.
Asset class diversification
Asset class diversification is an even broader form of portfolio diversification. Different asset classes perform differently in various economic environments. For Example, during an economic boom, stocks perform well while during an economic crisis, it is best to stay in fixed-income instruments such as bonds and bank deposits to protect yourself against capital loss. During the 2008 economic crisis, investors holding gold as a part of their diversification strategy made windfall gains due to a sudden surge in gold prices while those holding stocks suffered severe losses.
The Process of Diversification
Diversification is vital part of financial planning, since it not only protects portfolio against various types of risks but also maximizes return on capital at the same time. Diversification cannot be achieved by just throwing money in different stocks and assets. Proper diversification requires planning and depends on many factors. Following are the factors that you should keep in mind while diversifying your portfolio.
Your Investment Time Horizon:
Time is a great ally of an investor, longer investment horizons give better return on investments, when diversifying your portfolio, you should always take the time factor into account. If you have ample time in your hands, you can chose to invest a larger part of your capital in high risk high return assets such as stocks and mutual funds. If you do not have this luxury, chose safer investment assets such as high grade bonds, bank deposits and other fixed income instruments.
Your risk appetite
Risk appetite means your ability to take bigger risks. Your risk appetite depends on many factors such as your income levels, your monthly savings, age, financial responsibilities and nearness of your goal. An investor who is young and is able to save a meaningful portion of his income can take higher risk compared to someone who is middle aged, has many dependents (such as non working wife and kids) and has little savings left after meeting all his necessary expenses. The younger person will have a higher risk appetite compared to the middle aged guy, because former can still achieve his goals by saving and investing more than the latter one who has limited savings and less time in his hands.
Over diversification vs concentration
Although portfolio diversification is beneficial, too much of it may also do more harm than good. Diversifying your investments in too many assets may lead to poor growth, hindering your portfolio’s healthy growth. That is why, an investor should always be vigilant of his portfolio’s growth and check if it is growing fast enough to meet his financial goals.
Conclusion
Diversification is a battle cry for most of the financial planners, fund managers, it is as important as investing itself, while it minimizes your investment risk its purpose is to provide meaningful gains to an investor helping him achieve financial goals and have a comfortable retirement. By investing in a well diversified portfolio, and being disciplined in your savings and investments, you can slowly but surely achieve the life you always dream of.