Investment diversification is an investment strategy to reduce risk.
Diversification is perhaps the most trusted investment principle that is even followed by experts.
But the problem is that some people do not know the use of diversification.
There is one common misconception that diversification is related to high returns.
People think that diversification will maximise their returns.
But rather the opposite is true.
Investment diversification often averages the returns.
Investment diversification is an investment strategy that shall be used to reduce the risk of loss.
Risk/return trade-off will always be present.
The lower the risk the less in will be the probable return and vice versa.
Due to diversification, we reduce our exposure to risk.
As a result our probably returns also reduces.
Actually this is what happens due to investment diversification.
If we cannot make a big loss, will also not make big gains.
For a starter it may look like a big negative.
But for matured investors, rate of return is more important than regular compounding.
Keep investing regularly in consistent return generator.
Even small risk premium yield is good provided it is consistent.
Diversification is an investment strategy to reduce risk to zero?
Investment diversification cannot reduce the risk of loss to zero.
Some inherited business risks will always linger no matter how well the portfolio is diversified.
Stocks prices are bound to fluctuate on daily basis.
Irrespective of whether the company is large cap or small cap.
Short term volatility of stocks cannot be curtailed.
In short term stocks price may behave abnormally.
Hence, even a perfectly diversified portfolio pose risks to investors.
There are another conditions when investor can make a loss even though they carry a well-diversified portfolio.
In case of global financial crisis (what we saw 2008) even a perfectly diversified portfolio will face losses.
As all shares are falling in time of financial crisis, portfolio returns will be negative.
How to create a diversified investment portfolio?
In simple terms, just to explain diversification, people shall have two and not only one share in portfolio.
When one stock falls, there is a chance that the other will rise.
So this reduces the risk of loss.
When a portfolio has only one share there is no chance of negative compensation.
In case a portfolio has only one share, if its price falls, there is 100% chance that the portfolio will show red.
Diversification means buying shares of different companies?
Buying shares of different companies will not provide a good diversification.
Good investment diversification can be achieved only when stocks of non-related sectors are purchased.
Like shares of the following sectors:
- Steel sector,
- IT sector,
- Banking sector,
- Construction and contracting,
- Precious Metals/Jewellery,
- Energy (refineries),
- Retail, shipping, Textile etc
are examples of non-related sectors.
If shares of these sectors are purchased, it will provide good investment diversification.
Including only shares will not provide good investment diversification.
It is essential that following constituents are included in the investment portfolio:
There is one fool proof way of building a well-diversified portfolio.
This can be done by thinking to accumulate all types of asset class.
Instead of thinking only stocks or mutual funds, we shall focus on accumulating different asset class.
Diversification is an investment strategy to reduce risk of loss.
But this will happen only when one accumulates different asset class.
All asset class has their own characteristic risks.
Like stocks are very risky by cash in bank savings account is like zero risk.
Depending on one’s risk appetite, one shall appropriately select different investment options.