Portfolio diversification means distributing/allocating your wealth into different asset classes like equities, debt, cash, real estate, gold, art, etc. Before going in deep, let’s understand “What is Portfolio?” A portfolio is a collection of investments made by an individual or an institution to diversify his/her/its investment risk. Portfolio will help the investor to avoid the risk of losing money by investing only in a particular kind of avenue.
Understanding the concept of equity portfolio is very important for an equity investor. There are 5000 plus listed stocks in the market. But understanding where to invest, when to invest and how much to invest is very difficult. If you are investing all your savings in stocks of a specific sector, it will lead you to lose the entire money in case of any sectoral collapse. Because of these reason it is very important for an investor to maintain a balanced equity portfolio.
How much money one person can invest in equities? It is purely depend on the financial position and risk taking capacity of that person. Before investing one should understand his financial position and risk taking capacity. So that he can have a wise decision on his investments. The basic thumb Rule of equity investment is “100 – Age”. For example a person of 25 can invest 75% (100 – 25) in equities and remaining 25 percentage in other debt funds, if the person is in his 50s, he can invest only 50% (100 – 50) in equities and the rest in debt funds. Once when an individual has decided on the percentage of allocation towards equity investments, he should consider the following :
We have already mentioned that portfolio diversification means distributing/allocating your wealth into different asset classes like equities, debt, cash, real estate, gold, art, etc These asset classes have a certain return expectation and risk attached to it. Risk is defined as the uncertainty or variation in the return expected from an asset class. This risk could be measured in terms of standard deviation of an asset class. Risk can be categorized as below :
While diversifying the portfolio one should take into consideration the correlation between various asset classes. Correlation is the measure of the extent to which two asset classes move together in a given situation. If they move in the same direction it is positive correlation and vice-versa.
Adding negatively correlated or non correlated stocks in the portfolio will help you in reducing the unsystematic risk. Negatively correlated stocks will always perform in the reverse direction. It will help to prevent the loss of investment. In negatively correlated stocks if one stock is making loss the other will give you profit. It will help you to balance the loss. So it is always better to keep negatively correlated stocks or non correlated stocks in your portfolio. It is based on the fact that various asset classes behave differently as maturity & volatility of these assets differs.
Portfolio diversification could be achieved by designing model portfolios with the objective of diversifying the portfolio. The composition of different equity portfolios may differ across the class of stocks. For example, for some portfolios the investment universe may be restricted / focused on large-cap, mid-cap, small-cap or speciality stocks. Portfolio can be created according to the need, risk taking capacity, and income of the investor.
Consistency in investment management & portfolio positioning policies by the investment managers is the important factor that affects the efficient performance of a portfolio. Any deviation from the declared policy would lead to unexpected portfolio performance for the simple reason that the traits itself would have got altered.
For example, if an investment manager changes his investment management style from value investing to growth investing, the intrinsic allocations of the portfolio towards these traits would get altered and it will lead to unexpected performance.