While rising incomes and greater awareness are encouraging people to seek attractive investment options, volatility in the financial markets can still be overwhelming. Swift moves in asset prices and constant news flow often increase investor anxiety. In such a scenario, building a diversified portfolio makes sense. This means spreading investments across multiple asset classes and combining products that offer both assured and market-linked returns.
Why Diversify?
For the average investor, diversification acts like insurance – it protects your portfolio from being wiped out by the poor performance of any single asset class. It is rare to accurately predict how each asset class will perform. However, history shows that asset classes do not rise or fall together. By investing across asset classes - diversification - you can reduce the risk of loss in your portfolio and increase your chances of benefitting from opportunities spread across asset classes.
Types of diversification
Diversification can be achieved by spreading investments across asset classes - for example, investing in a mix of stocks, bonds, commodities, and real estate. It can also be done within a single asset class. For instance, an investor might choose a mix of safer avenues like government securities, AAA-rated PSU bonds, and bank fixed deposits; along with high-yield corporate bonds that carry relatively higher credit risk. Geographic diversification can also be explored. For example, an investor may allocate funds to American and Chinese stocks in addition to a core holding in Indian stocks.
A disciplined and well-thought-out approach can help make sense of the many options and guide better investment decisions.
How to diversify
Always start by identifying your financial goals and risk profile. For long term financial goals such as retirement, investors with moderate to high risk tolerance can allocate a relatively larger portion of their portfolio to risky asset classes like equities. For short-term goals, such as saving for a car down payment in the next year, safer instruments like bank deposits should be considered.
Investors should choose a mix of investments to achieve desired asset allocation. Here are some of the popular avenues, investors should consider:
Equities: Long-term investors keen on investing in stocks should consider staggered investments in diversified equity portfolios through unit-linked insurance plans, portfolio management services and mutual funds. Savvy investors may also invest directly in stocks. Equities have the potential to deliver relatively higher returns over the long term, generally outpacing inflation, although they come with bouts of volatility.
Fixed income: With a view to protect capital, many conservative investors prefer bonds and other fixed income investments. Though they barely beat inflation, tax efficient instruments such as Public Provident Fund, traditional endowment insurance policies offered by life insurers can help build a corpus over the long term. In the short-term, investors choose fixed deposits and debt funds for stability and predictable returns.
Gold: Gold, the most preferred precious metal is used as a hedge against inflation, market volatility and a strong US dollar. Gold typically generates returns in line with inflation. However, it can be very volatile, hence staggered investments through units of gold exchange traded funds may work better.
Real Estate: Investments in real estate can provide both rental income and capital appreciation. Though it is a high-ticket investment, real estate investment trusts (REIT) have made it accessible to retail investors.
While spreading investments across these asset classes can help generate returns and protect against downside, investors should regularly rebalance their portfolios. As an investor moves closer to a financial goal, the allocation to risky assets should gradually decrease to protect accumulated wealth. Both during the initial allocation and while rebalancing, taxation should be considered.
To sum up, diversification rewards investor by reducing risk and stress; offering a more stable investment experience. Over the long term, this disciplined approach can help investors build large pool of wealth that can be used to achieve various financial goals.
