Why should You Diversify Your Portfolio

July 14, 2009 Tuesday

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 :

Liquid and Less Risky
Portfolio Diversification
Give Importance to Market Timing
Do Reinvestment
Avoid fear based decisions

Liquid and Less Risky

If the stocks bought are of illiquid nature, it will be very difficult to redeem. Low price of illiquid stocks may attract you to buy those. But remember once the money is locked in such stocks it will be very difficult to sell off those and get back the money.

Portfolio Diversification

Investors should hold a diversified equity portfolio in order to reduce the risk of capital loss and to generate a balanced and reasonable return. Not maintaining a diversified portfolio might lead you to huge loss in certain circumstances.

Give Importance to Market Timing

Most of the investors don’t bother about the market timings they just want to make money. But the fact is that market timing is very critical for an investor to make good returns. It is very difficult to time the market, at the same time it is very important also, so be smart enough to buy at the absolute bottom and sell at the absolute top.

Do Reinvestment

Just investing in any stock doesn’t clear all your responsibilities. Always you need to have a relook at your investments. It is advisable to reinvest the money into another stock that meets the investor's own objectives in case the presently invested stock makes loss.

Avoid fear based decisions

It is very common that people withdraw their money from their investment when there is a small fall in the stock price. But this is a wrong decision, instead of selling off the shares you can purchase more quantity of same share for fewer prices and wait till the stock recovers. Your patience will be rewarded with huge profit.

To be an Equity Portfolio Expert, one has to understand many things. First of all he should know to match his age and the type of stock he has to invest. Because the risk taking capacity of an individual is depend on his age, as the age increases his responsibilities and liabilities will also increase as a result his risk taking capacity will reduce. For example; a person of 25 years, generally he won’t be married, as he is not married his responsibilities also will be less. A person with less responsibilities and considerable income can go for aggressive stocks, there the risk and returns are more. But a person of 35 years cannot follow the same strategy because he will be a married person with one or two kid. The responsibilities of a parent will be quite higher than that of a young person. So it will be effective to invest relatively lesser amount in aggressive shares and the rest in debt instruments.

Risk

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 :

Systematic Risk
Unsystematic Risk

Systematic Risk

Systematic risk is a kind of risk which arises in all the risky assets because of macro-economic factors like earthquake, floods, war, etc. It cannot be avoided through diversification. In short we can say that these risks are unavoidable.

Unsystematic Risk

Unsystematic risks are which that is exclusive to a particular asset class and could be avoided or reduced by diversifying a portfolio. In simple terms we can tell that unsystematic risks are avoidable. If you are able to diversify your portfolio properly, you will be able to avoid this risk.

How Diversification Helps in Eliminating the Unsystematic Risk?

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 Styles

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.

What Is Essential For Portfolios to Work Better?

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.