In recent times, everyone is on board with the idea that the best way to grow wealth is by saving and investing. There are many strategies for investing to maximise wealth generation, and the most frequently used is risk diversification of the portfolio. Here’s what it means to diversify risk and why you should do it.
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Have you heard the classic saying, ‘don’t put all your eggs in one basket’? Let’s go with a more relatable example, which is ‘don’t live on apples alone’. Apples sure have essential vitamins and minerals, but you will get a protein deficiency and other major health problems if you stop eating from other food groups. Similarly, suppose the only investments you have are real estate and a PPF account or FDs. In that case, you will lose out on the benefits of other assets, besides becoming vulnerable to losses if these assets underperform.
What is portfolio diversification?
Portfolio diversification is the practice of investing your saved funds in different asset classes either for generating wealth or getting regular income. They can include stocks from different industries and sectors, debt instruments such as bonds, mutual funds, real estate assets, gold among others. A diversified portfolio has many different asset classes and is not necessarily from investing in the markets of only one country.
The idea is to include various asset classes that have a low correlation with each other. Every asset class has a systematic risk because of the notions of the national and global economy. But, diversifying the portfolio reduces the unsystematic risk, that is the risk associated with factors directly impacting the specific asset. When the assets are not tightly correlated, the prices can move in different directions, balancing the whole portfolio.
Benefits of diversifying your portfolio
As you may have already gathered, having a diverse portfolio reduces your risk exposure to any single asset class. You will be less susceptible to market volatility, and your chances of losing your entire capital will come down drastically. To give an example, suppose you have a real estate investment, and the market takes a downturn, you will have losses in your portfolio.
If, on the other hand, some companies have well-performing stocks at this time and you invested in them, you could gain from there. By diversification of risk, you can have well-performing assets compensating for poorly performing ones.
So, how to diversify risk ideally depends on your risk appetite and financial goals. Many financial advisors recommend a 60:40 mix in stocks and fixed-income assets (like bonds and FDs), respectively. However, you may choose a higher stock investment if you can handle the risk or vice versa.
If you aren’t confident about your ability to analyse and pick the right stocks, you can opt for ETFs or mutual funds. For fixed-income assets, you can consider bonds, NSCs, PPF, FD and others. But remember that many of these assets have a lock-in period, during which you can’t withdraw the funds.
Do your research before settling upon the right mix of investments for effective risk diversification, whereby you can also meet your financial goals. The sooner you start, the greater is the potential for building enough capital to achieve your dreams.
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