Diversification of investments crucial to take you closer to your financial goal

Once you have identified your financial goals, the next step entails selecting the right investment instruments to achieve those goals. But how do you decide which investment option is right for you? If you plan to choose one high return investment to meet your goal faster, think again.

Investing can be tricky and requires a lot of deliberation. Choosing just one investment avenue is not enough anymore. You must step back and see the larger picture to understand why diversification matters. As the saying goes, avoid putting all your eggs in one basket. The same is true when it comes to investing. Instead of relying on one option, spread your investments in different asset classes or instruments so that you maintain the risk-reward balance. This concept is called diversification of your portfolio.

Take a scenario, say equities correct by 15% in a year. If you had invested largely in stocks or equity-based instruments, your portfolio would see some dents. On the other hand, if you had spread your investments across debt, equity, gold, and cash, your portfolio still would have decent returns. Chances that another asset class, such as gold, performed well in the year equities did not, is high. The scenario may change in the next year where equities could rally over 30% while other asset classes may not offer great returns, however by diversifying you can generate decent returns overall.

The other advantages of a diversified portfolio include:

Lowering the impact of volatility in the market: When you have a diversified portfolio, the impact of volatility on one set of assets is offset by a stable investment option.

Tapping into the benefits of different instruments: Each investment instrument or asset class has its unique qualities and by choosing a spread, you can benefit from the strengths of each one of them.

Spending less time tracking your portfolio: You can save time tracking your portfolio because a diversified portfolio brings stability. For instance, if you have invested in stocks alone, you will need to spend some time studying the movement of the markets. Similarly, if you have invested in debt instruments alone, you may have to spend time to understand how to boost returns. On the other hand, a diversified portfolio brings in a natural element of balance.

Even within an asset class, you should aim for diversification. Say you are investing in stocks. It is important to choose the stock of different companies and sectors to ensure that the good performance of one outweighs the average performance of others. Now that you know the importance of diversification, the next question is how much to diversify. You would need to follow certain asset allocation rules to ensure that you have a diversified portfolio.

First things first, look at where your investments are right now. Even a highly aggressive investor does not allocate all his wealth to equities. While you may have channelised your liquid assets into stocks, there are other investments like PPF or mutual funds, which you may have taken into account. So, the first step is to assess your allocation right now and see where your wealth is.

The next step is to take into account your age. Age is a key factor when it comes to asset allocation. A well-known thumb rule is that your equity allocation should be 100 minus your age; some peg that at 110 minus your age. The idea behind this thumb rule is that if you are a young investor, you can afford to have a higher equity allocation. Accordingly, if you are in the 25 to 35 age group, your equity allocation can be in the 65 to 75% range. The idea is that the younger you are, the fewer your commitments like a family, education of your children, etc. so you can afford some risk.

Ensure there is a debt allocation in your portfolio. Though returns from debt instruments are relatively lower, they offer steady returns and are ideal for those who are looking at a fixed income. Also, they are traditionally safer as they provide a cushion for your investments against market volatility. Debt products also ensure liquidity so you can use them in case of a contingency or any immediate financial needs.

Assess your capacity and willingness for risk. When you diversify your portfolio, you should also assess your willingness to take risks. Your investment philosophy could be aggressive, moderate, or conservative. The factors to consider include your source of income and the stage of your professional life you are in. If you have a steady source of income, your ability and willingness to invest in equity may be higher. As you approach retirement, you may have to look at your debt allocation and increase it. Look at the investment horizon and time left for your goal. The higher the investment horizon, the greater the benefit from equity as volatility comes down over a longer period.

Increase the equity allocation if the time horizon is more, say seven or ten years. On the other hand, you can shift from equity allocation to debt, the closer you are to the completion of your goal. If your goals are very close to completion, say in the one-two year range, you may avoid volatility even though the assets may seem to be high-performing ones.

Watch out against over-diversification. The right amount of diversification is important for you to achieve your goals. Diversification is very important but when you spread your wealth too thin, it can impact your returns. Over diversification happens when there are so many investments that the benefit of lower risk becomes irrelevant. For instance, you may have 100 different stocks in your portfolio, thinking that you have lowered the risk. But, when you look at your portfolio closely, you may not have an optimal number of high-performing quality stocks, which in turn affects your returns.

Lastly, don’t forget to assess your portfolio from time to time to ensure the ideal amount of diversification so that you can reach your financial goals. Some investors would do that by restoring the original allocation. Say you started with a ratio of 60:30:10 in equity, debt, and liquid assets. You may set a range of 5% plus or minus when you do so. Once the asset crosses that range, you can rebalance the portfolio and restore the original allocation. However, this may not always work. Investors would also have to look at the trends in the market. For instance, equity stocks may be available to buy at low valuations and you can rebalance your portfolio by adding more stocks. Allocation change is also done based on the price-to-earnings ratio or P/E of the benchmark indices. So, if the P/E of indices is more than 24, it is suggested that equity allocation be lowered and when the PE is below 16, equity allocation may be increased.

Diversification is an important aspect of any investment plan and helps you achieve your financial goals in a manner that balances risks and rewards. There is no one-size-fits-all plan and the right diversification is based on your income, age, ability and willingness to take a risk, and the nature of your financial goals. Considering all these factors can help you realise your financial goals more efficiently and effectively.