Beyond eggs in one basket: The art of diversification simplified!
Hedge your investment portfolio with diversification
‘Don’t put all your eggs in one basket’, is what we come across when we hear about diversification. Ever wondered what diversification really means?
Kudos to those who already know it and have been using it for making favourable investment decisions! For those who are still figuring out what diversification really is or want to hedge their investments against concentration risk, this article is for you.
Let’s understand with a story
Ram had just learned about the stock market and wished to make money through investments. He had saved some money over the few years. He decided to put all his savings into a single company’s stock. Ram believed that the company would generate incredible for him in the future.
However, things did not go as planned. Due to some unfortunate turn of events, the company faced unexpected challenges. The stock price hit the floor! Ram’s entire investment was tied to this one company. He lost all his money in no time. Ram was disappointed as he lost all his savings which he had accumulated for years.
Feeling discouraged but determined to learn from his mistake, Ram decided to seek advice from his friend Peter. Peter was an informed investor who had been investing for many years and had learned some valuable lessons through his investment journey.
To explain his point, Peter shared one of his experiences with Ram. Peter had invested in multiple companies across different sectors. One of the companies in which he invested did not perform as he expected and lost a lot of money in that company. However, Peter had diversified his investments by investing in multiple companies. As a result, the negative impact on his overall portfolio was minimized. Other companies continued to perform well, balancing out his losses.
Peter explained the concept of diversification is like putting your eggs across multiple baskets, if one of the baskets falls, you won’t lose all your eggs as they are safely put among other baskets. Similarly, if you put your investments across various assets or companies, the risk of a single investment wiping out all your money is reduced significantly.
Ram realized that putting all of his eggs in one basket was a mistake. He realized that diversifying his investments meant putting his money among multiple stocks, industries, or asset classes such as bonds or real estate. He could reduce his chances of losing everything if one investment did not perform well.
Ram embraced the idea of diversification from that point forward. He chose to invest in a diverse portfolio of stocks, bonds, and mutual funds. This strategy helped him in risk management and the potential for more consistent returns over time.
Ram began rebuilding his investment portfolio with his newfound knowledge. He understood that diversification would not ensure profits, but it would protect him from major losses. Ram was on his way to becoming a more well-informed and successful investor by allocating his investments wisely.
Now that you have understood what ‘don’t put your eggs in a basket’ really means, let’s dive a little deep into the subject.
How can you create your diversified portfolio?
Different investors have different risk and return preferences. Some investors don’t like taking much risk while others might tolerate depending on their risk appetite. An investor with a lower-risk preference would invest more in less risky stocks. On the other hand, an investor who can take a higher risk to earn higher return would invest in a slightly risky stock.
In the equity markets, companies are usually divided into three categories as per their market capitalization – largecap, midcap and smallcap. The largecap companies tend to be less risky compared to the other categories. However, the returns could be much lower than the others. On the contrary, smallcap stocks have higher risk but could generate much greater returns than largecap and midcap. The midcap companies lie in between largecap and smallcap.
An investor with less risk appetite would allocate more of his money to Large-Cap stocks followed by midcap and Small-Cap. This will ensure that the risk of losing money is minimal. On the other hand, an investor who has a higher risk preference would invest more of his in smallcap and midcap stocks. Note that the returns would be adjusted as per the investors' risk appetite.
While diversifying a portfolio according to market capitalization, an investor should also make sure that he is diversified across different sectors of the market. It is important to note that concentrating your investments on only one specific sector could be as risky as investing in one specific company. Because every sector is prone to some macroeconomic headwinds that could stagnate the performance of a particular sector. One sector outperforms the other during different economic phases. Hence, it is better to diversify across various sectors. This helps investors to protect their money from the concentration risk.
For instance, during the period of recession, most of the performance of the sector is under pressure. However, sectors such as FMCG perform well compared to the others. On the other hand, some sectors are cyclical. Which means, their performance is based on economic cycles. Commodity sectors such as metals are highly cyclical and could perform exceptionally well during their peak cycles. On the contrary, if the conditions are not so favourable, the entire sector is negatively impacted. If you diversified across various sectors well enough, your returns are balanced as each sector has its ups and downs during various economic phases. If one of the sectors in your portfolio is underperforming, others might make up for the losses incurred in a particular sector.
Is it possible to diversify even further?
Yes! If you think the stock market is a risky game to play, you could diversify your investments even further across various asset classes.
So what do you mean by an asset class?
There are many types of financial instruments where you can park your money to generate returns. For instance, the stock market is one such asset class in which you buy the shares of publically listed companies.
What are the other asset classes you can invest in?
Fixed income or bonds – Bonds are debt securities that are issued by companies, governments, or municipalities. When you invest your money in bonds, you are essentially lending money to the issuer of the bond in return for regular payments of interest and the repayment of the principal amount when the bond reaches maturity. Bond prices are affected by factors like interest rates, credit ratings, and the issuer's financial stability. Bonds can provide you a fixed rate of returns which makes them less risky compared to stocks.
Cash and cash equivalents – This asset class consists of highly liquid, low-risk, and cash-convertible investments. It includes things like money market funds, savings accounts, and certificates of deposit (CDs). Although they are typically seen as stable investments with little risk of loss, cash and cash equivalents typically provide lower returns than other asset classes.
Real estate investments – Real estate investments involve tangible assets like real estate investment trusts (REITs), commercial buildings, houses, or land. Real estate investments can generate revenue through rental payments or an appreciation in property value. Location, demand for specific types of properties, rental income, and general economic conditions all influence real estate earnings.
Commodities – Commodities are raw materials or primary goods that are bought and sold on commodity exchanges. Examples include crude oil, gold, silver, agricultural products (like wheat or corn), and industrial metals (such as copper or aluminium). Commodity prices can be affected by factors like supply and demand dynamics, geopolitical events, weather conditions, and global economic trends. Commodities can be physically owned or traded through futures contracts.
Alternative Investments – This asset class includes a diverse range of non-traditional assets other than stocks, bonds, and cash. It includes hedge funds, private equity, venture capital, derivatives, cryptocurrencies, and other unconventional investments. Alternative investments often have distinct risk-reward profiles and may require specialised knowledge or access. They are often less regulated and can provide diversification opportunities or possibly high profits, but they also pose higher risks. This asset class is meant for high-net-worth investors (HNIs) who can tolerate such high risks.
It is important to keep in mind that each asset class has its own risk and return characteristics, and their performance may differ over time. Portfolios that include various asset classes are frequently constructed by investors to spread risk and potentially optimize returns based on their investment objectives and risk tolerance.
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