‘Don’t put all your eggs donate basket might be the most used ‘ut significant advice for investors looking to minimize the impact of volatility on their portfolio.
Different asset classes and instruments have distinct quality, risks, and characteristics; therefore, their respective returns potential tend to vary over the same investment periods. When an investment portfolio includes different investment assets in an appropriate proportion based on an investor’s risk profile, it can enhance the portfolio quality and help to weather out all market phases without losing sleep. That is what ‘diversification’ is all about.
Diversification is a risk-mitigation strategy to offset ‘osses incurred by one asset class or instrument by the gains of other assets in the portfolio.
- Amongst Different Asset Classes.
- Within an Asset class.
So, in addition to allocating the investments among stocks, bonds, cash equivalents, and other asset categories, investments should be spread out within different asset categories. The key is identifying investments in each asset category that may perform differently under various market conditions.
One way to diversify the investments within an asset category is to identify and invest in a wide range of industries and sectors. However, this may only partially serve the requirement. For example, an industry or sector might be performing well, but the companies within that investor’s sector might not be. Won’t truly diversify; an investor should diversify the investments over different companies with a chosen industry or sector.
Why is Diversification Essential?
Minimize Market Risk
Different asset classes and investment products have specific risks. Therefore, investing in more than one asset or instrument can help the investors minimize the overall portfolio risk.
Exposure to Different Assets and Products
Diversification helps investors attain exposure to multiple assets like equity, debt & gold, etc., different sectors like IT, pharma & infrastructure, and investment styles like value, growth, momentum, etc.
Ride Volatility Across Different Market Cycles
Since different asset classes and sectors do not move in tandem, diversifying across assets and sectors can help you ride out volatility across market cycles, i.e., performing well in both growth and contraction phases of an economic cycle.
Achieve Optimal Asset Allocation
Investing in multiple investment assets and diversifying your portfolio based on your investment objective and risk tolerance level helps you build an optimal and long-term asset allocation strategy.
What is an Investment Portfolio?
An investment portfolio is a collection of financial securities that give an investor an attractive trade-off between risk and return. It is based on making investment choices on expected returns and risks.
The expected return is measured by the amount of profit anticipated over some relevant holding period. Risk is measured by return dispersion. Investors get a positive benefit or utility if there is an increase in the expected rate of return and suffer a psychic loss or disutility if there is an increase in the amount of risk or return volatility.
An equal investment in two securities with the same expected return and standard deviation but a perfect inverse correlation would create a constant return or zero-risk portfolio.
Types of Investment Portfolios
An investment portfolio would depend on various factors like; age, financial goals, risk appetite, etc. and could be broadly classified into three broad categories, namely:-
- Aggressive Portfolio
- Moderate Portfolio
- Conservative Portfolio
In general, an aggressive investment portfolio would be suitable for investors who look for high returns and have the risk tolerance, i.e., can endure wide fluctuations in value. This is characterized by increased investment in equities. An aggressive portfolio may consist of approximately 70-75% equities, 20-25% bonds, and 0-5% cash and equivalents.
A moderate portfolio is meant for individuals with a longer time horizon and an average risk tolerance. This investment portfolio would be suitable for those investors who want a balance of risk and return, i.e., could bear the limited risk and are comfortable with reasonable returns. It is also termed a balanced portfolio. A moderate portfolio would consist of approximately 50-55% equities, 35-40% bonds, and 5-10% cash and equivalents.
A conservative investment portfolio puts safety at the highest priority. This type of portfolio is appropriate for risk-averse investors. Generally, a traditional portfolio would consist of cash and cash equivalents or high-quality fixed-income instruments.
The main goal of a conservative portfolio strategy is to maintain the actual value of the portfolio or to protect the portfolio’s value against inflation. Percentage allocation in equity could be less or significantly less, say 10-15%, with the balance amount invested in cash and fixed income generating financial assets like bank FDs, Debt Mutual Funds, GOI securities, etc.
Conclusion: Investment Allocation for Investors
With asset categories with investment returns that move up and down under different market conditions within a portfolio, an investor can help protect against significant losses. Historically, the returns of the three major asset categories – stocks, bonds, and cash – have not moved up and down at the same time. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns.
Investing in more than one asset category can reduce the risk that investment would be lost, and a portfolio’s overall investment returns will have a smoother ride.