How Important is Diversifying your Portfolio?

What Is Diversification?

Diversification is the act of putting your investments across different asset classes like equities, bonds in a portfolio. This is essentially done to mitigate the risks that come with investing in only one kind of security.

An example to help you understand better

In a simpler language, suppose you put all of your capital into one small-cap stock ABC Ltd. If ABC Ltd has a strong bullish rally, then the profits you will reap will be definitely exponential to the initial investment amount. However, if the stock price plummets and never recovers, then you will have to suffer extensive losses and it could go up to losing the entire capital you had invested earlier in case of bankruptcy.

Now, let’s consider another situation wherein you want to divide your capital and based on certain weights, invest proportionately into 6 stocks wherein three are large-cap, two are mid-cap and one is a small-cap stock. Apart from stocks, you also want to invest in a different asset class so you buy a corporate bond.

In this portfolio, even if the small-cap stock plummets in price, you will be able to reduce the extent of losses by the returns of the other stocks (considering that they perform positively). Even if the entire stock market is hit and all your stocks underperform, you will be safeguarded by the investment you have made in the bond market and thus, able to neutralise the performance of your portfolio.

What are the ways to diversify a portfolio?

1. Understand your risk tolerance and decide the capital allocation you want to make to each security

By this time, I believe it is clear that we should have various investments in a portfolio. Now, we come on to an important question as to how to determine what the capital allocation we should make to each asset class?
It requires a broader discussion, but to make it simpler and specific, it depends upon the risk tolerance of an investor. Risk tolerance is the amount of loss that an investor can take or withstand in their portfolio. If your portfolio consists of 100% stocks, then you would be considered as having a higher risk appetite because stocks are not mandated to provide definite returns.
Conversely, a lower risk-taker would give a larger capital allocation to bond instruments (Gives fixed returns in the form of interest), ETFs or even commodities like gold or silver.

2. Low correlation among asset classes

Now, another important aspect of diversification is to invest in assets or securities with low correlation to each other.

Correlation measures the strength of the relationship between assets and determines the degree to which two assets move together. If two stocks in your portfolio are highly correlated with each other, then their movements in prices will also be identical; if one increases in price, the other will too and if one falls, the other one will fall as well.

The correlation of different securities in your portfolio should be ideally low so that the entire portfolio is not severely impacted by a loss in individual security.

Example of how correlation works:

Gold and Silver which are commodities (Asset class) are used as safe havens or alternatives for investment during financial turmoil or uncertainty, especially when it is reflected in the equity market.

If two pairs of assets offer the same return at the same risk, choosing the pair that is less correlated decreases the overall risk of the portfolio.

Diversifying options in the stock market

In the stock market as well, large-cap, mid-cap and small-cap stocks have varying degrees of risk associated with themselves. It is always better to have a larger proportion of your portfolio built with large caps because these are established companies with a lot of cash and hence, will provide you definite returns and low-risk exposure. Growing mid-cap companies can provide you with better returns but with more exposure to risk. Small-cap stocks are the riskiest among all the types because, in phases of financial turmoil, they do not usually have the liquidity or cash support to mitigate the losses and survive. An investor should have the lowest capital allocation to small-cap stocks to prevent any major losses.

Diversification and how it works is rather a really large area of discussion. This article was made to shed some light on the important details; however, we will keep on publishing to help you understand diversification in its entirety.

In case you have any doubt about this topic, you can ask your questions in the comment box, we will try to answer your question as soon as possible.

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How Important is Diversifying your Portfolio?