Diversification is investing in investment options to limit the exposure to any particular asset class or investment. This practice helps to reduce the risk associated with your portfolio. Simply put, diversification helps you to yield higher returns as well as reduce the risk in your portfolio. Balancing your comfort level with risk against your time horizon is one of the keys to a long successful investing journey. For e.g., keeping pace with inflation may not be easy if you start investing in conservative investment options from a young age. On the other hand, taking a large exposure in high-risk instruments near retirement could erode the value of your portfolio. Hence, it is important to balance the risk and reward in your portfolio so that you don’t lose sleep on market ups and downs.

What are the components of a diversified portfolio?

The major components of a diversified portfolio are equity, debt and money market instruments.

Equity investments carry the highest risk in your portfolio and it has the potential to give higher returns over the long run. But with higher return comes greater risk especially in the short run. Equities tend to be volatile than other asset classes. Investing in equity mutual would be the best way to take exposure in equities. Equity mutual funds are diversified funds as fund managers invest in different stocks and across sectors (except sectoral funds) which optimizes the risk in your portfolio.

Another important component of a diversified portfolio is debt securities. While equities have the potential to grow your wealth, debt investments provide stability and act as a cushion through the market cycles. Debt instruments include debt mutual funds, fixed deposits, bonds etc. The main objective of debt instruments is not to provide high returns like equities but capital protection along with inflation-beating returns. Debt investments can also be a source of income.

While equity investments give higher returns and debt instruments protect the capital to help us fulfil our financial goals, a part of the portfolio should be in liquid and money market instruments such as liquid mutual funds or a separate savings account. It provides easy access to money during emergencies such as job loss or accident.

Why is diversification important?

Diversification helps to minimize the risks associated with your portfolio. Let us assume that two years ago, you had invested your entire savings in a particular airline stock. Now, the airline is near bankruptcy and the stock price went down 60% in one month. Would you be comfortable in that kind of scenario? Most people wouldn’t. You would have less stressed out if you had diversified your portfolio and invested in a few other companies rather than taking 100% exposure in one particular stock.

Diversification is important because different investment options react differently to the same development or move in a different pattern. For example, real estate and gold tend to underperform when equity markets are soaring. A cut in the interest rate may benefit the bond market but may not be good news for individuals with fixed deposits.

How to diversify your portfolio?

Diversifying your portfolio is as healthy as consuming green leafy vegetables, fruits, exercising and meditating on a regular basis. However, eating just one kind of fruit may not be very effective. Hence, it is important to diversify. Investment is no different. Here are some of the ways through which you can diversify your portfolio:

Spread your investments among different asset classes: A diversified portfolio should include equities, debt and cash. Exposure to international market and commodities such as gold can help you in further diversifying your portfolio. It is because different investments come with different risk and returns. Higher the returns, higher will be the risk and vice versa.

Diversify within individual types of investments: Diversification is also necessary within an asset class. For e.g. in case of equity mutual funds do not concentrate on one category. It is recommended that you have mutual funds across market capitalization such as large cap funds, mid cap funds and different investment strategies. Different funds and stocks come with varying risks thus minimizes the risks.

Rebalance your portfolio regularly: Diversification is not an one-off exercise. Rebalancing your portfolio depends on two important things which are the number of years until you expect to need money(time horizon) and risk-taking capacity(risk tolerance).

To summarize, diversification is important for every investor whether it is across asset classes or within an asset class. The nature of diversification depends on financial goals, time horizon and risk tolerance. It is also important that the diversification of the portfolio is updated on a regular basis.