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How portfolio diversification can help you reduce investment risk

Written by Sahas Gulati

Diversification is the finance equivalent of not putting all your eggs in the same basket. However, there are several factors to consider and pitfalls to avoid in order to successfully create a diversified portfolio.

Portfolio diversification is a way of minimising risk in order to achieve higher risk-adjusted returns.

Diversification works within one asset class as well as across multiple asset classes.

The average investor can achieve effective diversification by investing in a combination of equity and debt mutual funds.

False diversification and over-diversification are two common pitfalls every investor should watch out for.

Greater risk leads to greater reward. Or does it? When it comes to investment portfolios, this may not necessarily be the case.

 

In finance not all risks are the same. When you buy an investment asset, say shares of a company listed on the stock exchange, you take on two different types of risks - company-specific risk associated with management decisions and other factors unique to that one company, and systematic risk associated with factors that impact the broader asset class of equity shares.
 

The crucial difference between the two types of risks is that higher systematic risk is associated with higher portfolio returns, while higher company specific risk is not.
 

The fundamental objective of diversification is to minimise the company specific risk that does not earn you higher returns. This is achieved by holding multiple assets (in this case, shares of multiple companies) so that potential loss in the share value of one company is averaged out by the gains in other shares in the portfolio.

How to diversify your investment portfolio

For the average investor, the most convenient and cost-effective approach for achieving diversification is to opt for mutual funds. A typical equity mutual fund portfolio will comprise at least 30 different stocks, and give you all the benefits of diversification. Similarly, debt mutual funds hold bonds issued by multiple private and government organisations to achieve a diversified portfolio.

 

It also helps to diversify across multiple asset classes. As an example, investing in both equity and debt mutual funds is an effective way of creating a corpus for long-term financial goals. Since the returns on equity and debt mutual funds are not perfectly correlated (i.e. your equity and bond portfolios will not go up or down by the same value at the same time) such a portfolio can help you achieve a lower portfolio risk appropriate for the time horizon of your financial goals.

Be wary of false diversification

You end up with false diversification when you have multiple assets in your portfolio, but the returns on those assets are highly correlated. In other words, you put your eggs in different baskets, but all baskets are alike.
 

A common form of false diversification is slicing up the same market segment into smaller and smaller pieces. For example, spreading your investments across shares of large-cap, mid-cap, and small-cap companies will not reduce risk if these companies belong to the same sector, or are otherwise exposed to the same risk factors. A sign of false diversification in your portfolio is that all your assets are going up or down in value at the same time. In fact, don’t let positive returns fool you; if all assets are going up in value at the same time, they are likely to come down together as well.

The cost of over-diversification

 

When it comes to portfolio diversification, you can have too much of a good thing. At some point the cost of diversification exceeds the potential benefits. Pursuing diversification for the sake of diversification can harm your portfolio in two serious ways:
 

Firstly, it can potentially dilute the portfolio strategy that drives long-term returns. Take the example of mutual funds. A fund manager usually deploys an active strategy to generate returns in excess of the target benchmark; the unit holder (i.e. you) pay a fund management fee (expense ratio) in return. By holding too many mutual funds with divergent portfolio strategies, you negate the impact of active fund management that you are paying a fee for.
 

Secondly, over-diversification usually comes at the cost of sustainability. One of the attributes of a good portfolio is that the investor understands the underlying rationale, potential returns, risk factors, and how the securities in the portfolio interact. Adding too much to the mix complicates this understanding, potentially forcing the investor to spend inordinate amount of time managing her investments.

Periodic rebalancing

 

Once a diversified portfolio has been set up, it requires periodic monitoring, and if required, rebalancing. The rates of return vary across assets, which may increase the weightage of some assets relative to others in your portfolio. It is important to guard against this unintentional risk concentration over time, and to make sure that your portfolio stays true to your investment objectives and financial goals.

Published on: September 5, 2018

Blog › Investing › How portfolio diversification can help you reduce investment risk

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