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What is portfolio diversification?
We’ve heard many times that ‘Don’t put all your eggs in one basket ‘. These words perfectly replicate that you shouldn’t risk all your money on one investment.
Portfolio diversification is the process of allocating capital into different assets to avoid risk. Investment capital can be diversified into various assets like real estate, stocks, bonds, gold, etc.
The fundamental objective of portfolio diversification is to minimize risks and volatility. As per my concern, an ideal portfolio must have at least 5 asset classes.
Diversifying a portfolio reduces uncertainties since all equities, sectors, or companies are in different asset classes which do not move together. Having a diverse portfolio of non-correlated investments can almost reduce market risks.
Portfolio diversification differs from person to person. As per their age and risk-taking capacity, for example, a young individual can take higher risks and invest a major portion of their capital in equity markets for higher gains than an elderly person who is close to retirement. We will further study how to diversify your portfolio across different assets. So, stay tuned.
Now that you know almost everything about portfolio diversification, let us now study a brief about a not-so-similar strategy called “portfolio management”.
What is Portfolio Management?
Portfolio management is the process of compiling and monitoring a selection of investments to meet your objectives while staying within your risk tolerance. The goal is to create stability and minimize risks to find certainty in the future.
Portfolio management is done in two ways: Actively or passively.
- Active portfolio management generally involves buying and selling stocks & assets in an attempt to outperform the broader market.
- Passive portfolio management means matching the index by buying a similar composition. That way, you’ll make the same return without having to spend as much time on it.
When managing a portfolio, it’s important to find the right balance between risk & reward. Portfolios could feature a mix of stocks, bonds, and other financial investments to construct an effective strategy to gain maximum profit.
How to diversify your portfolio?
1.Invest in stocks of different sectors
The allocation of capital to different sectors is one of the most efficient ways to diversify the portfolio. Investing all the capital in a single sector can be dangerous.
If the sector falls due to an economic downturn, stocks belonging to that sector will have a negative impact on our portfolio. Hence, it’s important to diversify your investments in different growing sectors of the market.
2. Geographical diversification in stocks
Geographical diversification refers to investments in stocks abroad, i.e., US stocks like Tesla, Microsoft, Netflix, etc. With advanced technology and increasing globalization, investors can now invest in the stocks of various foreign companies.
Geographical diversification can also be done by investing in stocks that have global exposure that belong to the same stock market.
3.Invest a small amount in for fixed instruments.
Fixed income instruments such as government bonds, fixed deposits, etc. may not provide higher returns compared to stocks, but they play an important role in portfolio diversification. Because they are less volatile, they reduce portfolio risk and can deliver consistent returns.
I recommend you have some bonds in your portfolio, which might not be that profitable but can give higher returns than fixed deposits for sure.
4.Investment in cryptocurrencies
Although investing in cryptocurrencies seems extremely dangerous, if we look at the past, cryptocurrencies have brought great benefits to their investors. They are highly volatile, so I recommend that you invest only the amount of money that you are willing to lose.
Taking risks can be dangerous, but in today’s world, not taking any risks is the biggest risk. So, if you think you have the capability to handle higher risk for higher returns, cryptocurrencies are among the best investments to make.
5.Invest in real estate.
Investing in real estate can be done in many ways, such as buying a store, a house, a hotel, etc. But REITS, which stands for REAL ESTATE INVESTMENTS TRUST, is one of the most simplified ways to invest in real estate with a minimum amount of as low as 50,000 Rs. REIT companies own many types of business locations and lease them to businesses that need them.
6. Investment in gold
Last but not least, gold is the most popular investment asset in India. Investing in gold is always worthwhile because it has been in line with the rate of inflation. As gold has an inverse relationship with the stock markets, it reduces the risk in our portfolio. So, don’t forget to add gold to your portfolio to manage risk.
Factors to remember while doing portfolio diversification
1. Don’t over diversify your portfolio:
Over diversification means investing in too many stocks or assets. It is the most common mistake investors make when diversifying their portfolios. Although the risks in the portfolio are reduced, it hinders high returns on investments.
An ideal portfolio should have a maximum of 7 asset classes and > 20 stocks. Due to over-diversification, you won’t lose much, but you won’t gain much either so make wise decisions with proper research.
2. Don’t try to eliminate the risks
Portfolio diversification certainly helps reduce market risks, but we can’t eliminate them. Although we can reduce the risks associated with stocks (unsystematic risks), we cannot control market risks (systematic risks).
Market risks, such as currency depreciation, market crashes, etc., cannot be controlled. As per my concern, try to manage risk, instead of avoiding it, because every investment comes with some risk that can’t be avoided.
3. Beware of tax complications
Taxation is a major complication in portfolio diversification. The tax structure differs for different assets. For example, the tax structure of real estate is very different from that of fixed instruments.
One must be aware of the different tax structures when investing in different assets. It’s recommended to have a CA or financial advisor for handling your taxes, if you have large capital to manage,
Portfolio diversification is a difficult task to accomplish. Especially when you lack financial knowledge. But you can learn anything, no matter what educational stream you’re in, whenever you want. Make sure you get some financial knowledge before you invest in any asset. According to Warren Buffett, “Broad diversification is only required when investors don’t understand what they’re doing.”
As a smart investor, one should try to diversify the portfolio in such a way that we reduce market risks but are also profitable at the same time. Properly balance your portfolio between risk and return to get good returns on your investments without worry.
You can do it !
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