Diversification – A risk management strategy

‘Don’t put all your eggs in one basket’ is a saying that simply explains what diversification is.

Diversification is the process of spreading your investments across different asset classes, countries, industries, and individual companies. It is a technique used to reduce the risk arising from holding an single asset in your portfolio.

A portfolio should be well diversified and consist of a combination of assets, to reduce the overall expected risk. By spreading out the risk, you lower the odds of all your investments falling at once, as all assets do not move in the same direction and grow at the same rate in a particular period of time. There are various sophisticated techniques used by professionals to construct a well diversified portfolio.

A few simple facts you could bear in mind to achieve a certain a level of diversification in your portfolio.

The traditional way to diversify is by investing across asset classes, such as equity, debt, real estate etc., as per your investor profile. You could also invest in alternative assets such as precious metals and other collectibles to further broaden your portfolio. The drivers of each asset class vary, hence you should construct a portfolio comprising of assets that move differently in different economic conditions. You can also diversify your investments within an asset class itself. You should invest in stocks of different sectors and industries, as each company is exposed to individual risks of its own. While certain economic conditions might be conducive for the growth of a particular industry or company, another stock might fall under the same conditions. Thus your portfolio must consist of a variety of stocks from varying industries to achieve proper diversification.

You can also diversify your portfolio by investing across geographies worldwide, as each region is exposed to a different set of regional risks, and has a different growth cycle from other economies. Thus by investing across regions the risk of making losses from a particular underperforming economy could get offset by the gains from another booming economy. In today’s globalised markets it has become much simpler to invest overseas, through various foreign funds and also through mutual funds that invest in foreign markets.

Diversification has become even more important today, as in volatile markets asset classes move differently, some move up some come crashing down. In such challenging times diversification can significantly reduce the risk arising from exposure to an individual asset class.

As a retail investor, you can take advantage of diversification by investing even in small amounts in well balanced mutual funds.

However, you must be careful not to over diversify, as over diversification can reduce the expected returns to very low levels.

It is also important to remember that no matter how diversified your portfolio is, the risk can never be eliminated completely, it can only be reduced. Therefore you must construct your portfolio in accordance with your investment goals, time horizon and risk appetite.