Akash Jha
When the market is thriving, it appears nearly impossible to sell a stock for less than the price you paid for it. However, because we never know what the market will do at any given time, we must never underestimate the importance of a well-diversified portfolio in any market environment.
The investment community preaches the same thing the real estate industry promotes for buying a house when it comes to building an investing plan that mitigates potential losses in a bear market: “location, location, location.” Simply simply, never put all of your eggs in one basket. This is the key idea that underpins the concept of diversification.
Continue reading to learn why diversification is crucial for your portfolio and five recommendations to help you make wise decisions.
KEY TAKEAWAYS
- Investors are warned to never put all their eggs (investments) in one basket (security or market), which is the central thesis on which the concept of diversification lies.
- To achieve a diversified portfolio, look for asset classes that have low or negative correlations so that if one moves down, the other tends to counteract it.
- ETFs and mutual funds are easy ways to select asset classes that will diversify your portfolio, but one must be aware of hidden costs and trading commissions.
What Is Diversification?
Diversification is a rallying cry for many financial advisors, investment managers, and individual investors. It is a portfolio management method that combines many investments into a single portfolio. Diversification assumes that a wide range of investments will produce a higher return. It also implies that by investing in several vehicles, investors will experience fewer risk.
5 Ways to Help Diversify Your Portfolio
Diversification is not a new notion. With the benefit of hindsight, we can examine the gyrations and reactions of the markets when they began to wobble during the dotcom crash, the Great Recession, and again during the COVID-19 recession.
We must remember that investing is an art, not a reaction, and that the time to practice disciplined investing with a diversified portfolio is before diversification becomes a necessity. By the time the ordinary investor “reacts” to the market, 80% of the harm has already been done. Here, more than anywhere else, a good attack is your best defense, and a well-diversified portfolio combined with a five-year investing horizon can weather most storms.
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Here are five pointers to aid you with diversification;
1. Spread the Wealth
Equities can be fantastic, but don’t put all of your money into a single stock or sector. Consider creating your own virtual mutual fund by investing in a few companies that you know, trust, and even use on a daily basis.
But stocks aren’t the only thing to think about. Commodities, exchange-traded funds (ETFs), and real estate investment trusts (REITs) are also options. And don’t limit yourself to your own home base. Think outside the box and think globally. You will diversify your risk in this manner, which may result in larger benefits.
People would say that investing in what you know will lead to the average investor becoming overly focused on retail, but knowing a firm or using its goods and services can be a healthy and wholesome approach to this sector.
However, avoid going overboard. Make a point of sticking to a small portfolio. It makes no sense to invest in 100 different vehicles when you lack the time and money to maintain up. Try to limit your investments to 20 to 30 different ones.
2. Consider Index or Bond Funds
Consider including index funds or fixed-income funds in your portfolio. Investing in securities that mirror several indices is a great way to diversify your portfolio over time. You can further protect your portfolio from market volatility and unpredictability by include some fixed-income products. These funds attempt to mimic the performance of broad indexes, thus instead of investing in a single sector, they attempt to reflect the value of the bond market.
Another advantage of these funds is that they frequently have cheap fees. It means you’ll have extra money in your pocket. Because of what it takes to run these funds, the administration and operating costs are modest.
One disadvantage of index funds could be their passive management. While hands-off investing is often low-cost, it can be wasteful in inefficient markets. Active management can be advantageous in fixed-income markets, for example, particularly during difficult economic times.
3. Keep Building Your Portfolio
Invest on a regular basis. If you have $10,000 to invest, try dollar-cost averaging. This method is used to help smooth out the peaks and valleys caused by market volatility. The concept behind this technique is to reduce your investment risk by investing the same amount of money over time.
Dollar-cost averaging is a method of investing money on a regular basis in a specified portfolio of securities. Using this method, you’ll buy more shares when prices are low and less when prices are high.
4. Know When to Get Out
Buying and holding and dollar-cost averaging are both good investment strategies. However, just because your assets are on autopilot does not mean you should ignore the forces at work.
Maintain your investments and be aware of any changes in overall market conditions. You’ll want to know what’s going on with the companies in which you’ve invested. You’ll also be able to recognize when it’s time to cut your losses, sell, and move on to your next investment by doing so.
5. Keep a Watchful Eye on Commissions
If you are not a trader, be sure you understand what you are getting for your money. Some companies charge a monthly fee, while others impose a transaction cost. These can certainly build up and eat into your profits.
Be conscious of what you’re paying for and what you’re getting in return. Remember that the lowest option is not necessarily the best option. Maintain an up-to-date record of any changes to your fees.
Today, many online brokers offer zero-commission trading in a wide range of stocks and ETFs, making this aspect less of an issue. Trading mutual funds, illiquid equities, and alternative asset classes, on the other hand, is frequently charged a fee.
Why Should I Diversify?
Diversification enables investors to avoid “putting all of their eggs in one basket.” If one stock, sector, or asset class declines, others may increase. This is especially true if the securities or assets held are not highly connected. Diversification minimizes the overall risk of the portfolio without reducing the projected return.
Are Index Funds Well-Diversified?
An index fund or ETF, by definition, duplicates a specific index. Depending on the index, it may be more diverse than others. For example, the S&P 500 contains over 500 stock components, whereas the Dow Jones Industrial Average has only 30, making it significantly less diverse.
Even if you own an S&P 500 index fund, your portfolio is not always diversified because you should also include other low-correlation asset classes, such as bonds, as well as reasonable allocations to commodities, real estate, and alternative investments, among others.
Can I Over-Diversify a Portfolio?
Yes. If adding a new investment to a portfolio raises its overall risk and/or lowers its projected return (without correspondingly lowering the risk), it does not satisfy the purposes of diversification. This “over-diversification” occurs when a portfolio already contains an optimal amount of stocks or while adding closely-correlated securities.
Also read :- An SIP of ₹10,000 in this mutual fund would have grown to ₹2.1 crore in 21 years
The risk of a diversified portfolio is assessed by the total standard deviation of returns. The greater the standard deviation, the greater the estimated riskiness.
The Bottom Line
Investing can and should be enjoyable. It has the potential to be instructive, enlightening, and fulfilling. Investing may be rewarding even in the worst of circumstances if you take a disciplined approach and use diversification, buy-and-hold, and dollar-cost-averaging tactics.
