Portfolio diversification – importance of choosing right asset class

Remember the game of hide & seek you must have played as a child?

What was the strategy you implemented back then? Every member of the team should hide in a different place so that the seeker is not able to find all the players.

In essence, this is what diversification is all about when it comes to investing. Let us see in detail the benefits of diversification –

What is Portfolio Diversification?

Portfolio diversification is the process in which you allocate some portion of the portfolio in the different asset class (such as gold, equity, etc.). Imagine you invested your entire portfolio in equities and Covid-19 happens. While the market started recovery in a month after the correction but it dampens your liquidity and financial preparedness.

So, what is the purpose of diversification?

Simply put, the fundamental purpose is to minimize the risk on your investments; specifically, the specific risk associated with the market.

How do you diversify?

An investor can spread out investments by way of the following –

Spread out your investments –

Investing in equities is good, but that doesn’t mean you should put all your wealth in the same investments. It would help if you also considered investing in other asset class such as gold, real estate, fixed deposits, etc.

Explore other investment avenues

Consider adding You could also add other investment options and assets to your portfolio. Mutual funds, bonds, real estate and pension plans are other investments you can consider. Also, make sure that the securities vary in risk and follow different market trends.

Consider Index or Bond Funds

Adding index fund to your portfolio is a sound strategy to be with the market. These are a highly cost-effective investment instrument. Merely investing in an index fund, your wealth would have grown 1.45x in 71 months (see chart below).

Amount Invested Rs 7,10,000
Amount Accumulated Rs 10,27,616
Annual Returns, XIRR (%) 12.38

Source: Value Research, EduFund Research

Consider adding foreign assets

While India offers a great story of growth considering its young population, but we cannot rule out the volatile currency of the economy. For goals such as sending a child abroad for education, you must diversify currency risk. The rupee has depreciated at 5% over 10 years, thereby getting devalued. Also, it is seen that USD dominated assets have performed well over the years, generating 10% annual returns against Indian assets that generated 7%.

USD

INR

Date 100 USD in Sensex 100 USD in DJIA 100 USD in Sensex 100 USD in DJIA
Sep-10 100.0 100.0 4598.6 4598.6
Sep-20 189.7 257.5 13964.7 18959.1
CAGR 7% 10% 12% 15%

Note: CAGR – Compounded Annual Growth Rate

Source: Yahoo Finance, BSE India, EduFund Research

Reasons of performance –

  • DJIA grew at 10% CAGR in past years ending Sep-2020 whereas Sensex grew at 7% CAGR during the period
  • Rupee has depreciated at 4.8% CAGR over 10 years ending Sep-2020

One of the significant and most important benefits of diversification is that the portfolio can absorb shocks during a market downturn. The risk gets evenly spread out across asset class, and if you are saving for an investment, the likelihood of you getting derailed from your track gets minimal.

Key Takeaways

  • Diversification is a strategy that allows mixing a wide variety of investments in a portfolio.
  • Portfolio can be diversified as per asset class both within the class and also geographically
  • Diversification helps in optimizing risk-adjusted returns

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