Investing your money can be an effective way to increase your wealth over time. But diversification is one key element investors often need to pay more attention to in their quest for returns. While investing in a single stock or sector can yield profits, the risk is much higher because you put all your eggs in one basket.
Diversifying your portfolio is essential to reducing the risk of losses and ensuring long-term financial stability. Let’s delve deeper into portfolio diversification and why diversifying is so crucial for any investor.
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What is a diversified portfolio?
Portfolio diversity is a strategy to select a variety of investments with different risk and return characteristics to maximize financial returns. An investment portfolio that reflects good diversification across asset classes, sectors, geographical locations, and industries can reduce market risk and volatility.
With a diversified portfolio, you can ensure that if one sector or segment underperforms, it will not affect the entire portfolio. For example, if you only invest in stocks but then decide to add bonds to your portfolio, you can take advantage of fixed-income securities when stocks may be too volatile or expensive.
Diversified portfolio example
An example of a diversified investment portfolio includes different asset classes, such as bonds, stocks, and other securities. However, that’s not all. An intelligent investor should further diversify by investing in shares of different companies and industries.
This diversification can be accomplished by investing in stocks from transportation, retail, and consumer staples while buying government- and corporate-issued bonds.
Adding money market accounts and cash equivalents to the mix is also beneficial. The more diversified the portfolio is—in terms of the number of asset classes and the components within each class—the more protected it is against volatility or massive losses when markets dip or decline.
Four reasons why diversification is essential for your portfolio
1. Exposure to different sectors
Diversification is essential for your portfolio as it helps you get exposure to different sectors, thus reducing the risk of all your stocks losing value if one sector underperforms. For example, many sectors took a hit during the pandemic, but some, like pharmaceuticals, thrived.
If you had diversified your portfolio, you would have been able to offset some of the losses from other sectors with the gains from this one.
Diversification in investing is vital for any investor, but it can be beneficial if you need to access cash quickly. When you diversify your portfolio, you can include a few liquid investments that can be easily converted to cash. This way, if you ever need money in an emergency, you can sell off a portion of your investments and have the cash you need within 1-2 working days (in most cases).
3. Better risk-adjusted returns
You can achieve greater risk-adjusted returns by holding a mix of uncorrelated or inversely correlated assets that tend to move differently under various economic conditions.
For example, suppose you have a portfolio that consists exclusively of stocks. Over the long run, stocks have historically provided higher returns than bonds; however, they have also been more volatile, meaning their prices can fluctuate. If the stock market were to experience a sharp downturn, your portfolio would also likely lose value.
Assume you add some bonds to your portfolio along with stocks. Bonds tend to be less volatile than stocks, so they can help offset the market’s fluctuations. And because bonds provide different returns from stocks – for example, when interest rates rise, bond prices usually fall – adding them to your portfolio can also help increase its overall return potential.
4. Diversified portfolios are more tax efficient
Having a diversified portfolio can help you save on taxes. It is because different types of investments are taxed at different rates.
For example, short-term capital gains on equity-oriented mutual funds are taxed more than long-term capital gains. A tax rate of 15% is applicable on short-term capital gains from equity-oriented mutual funds. Meanwhile, long-term capital gains on these funds are taxed at 10%. It applies to gains that exceed Rs 1 lakh in a year. Thus, holding a mix of both short- and long-term investments can minimise your tax liability and maximise your returns.
One can also claim tax deductions on certain investments up to Rs 1.5 lakh a year under Section 80C of the Income Tax Act, 1961.
It’s important to remember that no one can time the market perfectly. Hence, it’s best to have a diversified portfolio to help you ride out any volatility in the market. Also, your income, risk appetite, investment objective, liquidity needs, and horizon should all be considered when deciding how to allocate your assets.
Most importantly, review your investments regularly and rebalance them as needed to stay on track with your financial goals.