IMPORTANCE OF PORTFOLIO DIVERSIFICATION

IMPORTANCE OF PORTFOLIO DIVERSIFICATION

WHAT IS PORTFOLIO DIVERSIFICATION?

It is a process of investing your funds in different types of asset classes in order to minimise the overall risk of the portfolio. Just imagine what would happen if you invested all your funds in a single asset class. Everything will be great as long as the share’s performance is good. But in case the market takes a sudden dip or u turn, you can stand to lose all your investments in a single hit. 

The primary purpose of portfolio diversification is to minimise the risk aspect on your invested funds, specifically unsystematic risk. This risk is also known as specific risk that is related to a particular company or industry. By diversifying your portfolio, this is the risk you hope to eliminate. In this way, all the funds will not be uniformly affected in the same way by market events.

MERITS OF DIVERSIFICATION 

1. Better weather market cycles:

Every economy witnesses a cycle. During a cycle, the market goes upwards, becomes stagnant, then comes down and goes up again. With diversification, you can better weather market cycles and take advantage of its bullish run. Also, following a crash when the market goes up, it assists you to gain from the rally. This is not the case, nevertheless, with a non diversified portfolio that is focused towards one asset class. 

2. Makes your portfolio prone to shock:

This is one of the major advantages of diversification. A well diversified portfolio can absorb the shock in a better way during a market downturn. The risk is spread out when the funds are invested in different asset classes. 

3. Provides stability:

Another major advantage of diversification strategy is that it assists the portfolio with the much needed peace of mind and stability, it can combat a downturn in a better way. With a more predictable return, it cuts out the emotional factor from investments, essential for achieving the desired goal. 

4. Enhance risk-adjusted returns:

This is another major advantage of diversification. When two portfolios yield the identical returns, a diversified one will take a lesser amount of risk than a concentrated one, The former will be less volatile than the latter. Therefore, for better risk adjusted returns, it is important to have a diversified portfolio investing across a range of asset classes. 

5. Leverage growth opportunities present in various sectors:

When you invest across various assets in different industries and sectors, you can leverage from the growth opportunities present in them. For example, of late gold has given phenomenal returns and those having an exposure to the yellow precious metal have made quite significant gains. Markets often see a cycle when one industry or sector outperforms another, and only when investors have the exposure to this sector, can you take benefit.

DOWNSIDES OF DIVERSIFICATION

1. Tax Complication:

This is a major drawback of diversification. The tax structure differs across asset classes and trading them can lead to major complications. For instance, the taxation structure of equity funds differs from that of Debt funds. Identically, income from bank FDs is taxed differently from real estate. Therefore, investors need to be well aware of the various tax structures while investing in different asset classes. 

2. Complicated investments:

When there is too much diversification, investments can get complicated. Before proceeding investors need to understand the structure and working of the asset class and this can be too much of a task. On the other hand, when you invest in only some asset classes, complications tend to be on the lower end. 

3. Going overboard:

Sometimes in the shadow of diversification, investors tend to go overboard and end up investing in too many assets that they don’t even need. For example, investors end up investing in a few crypto coins that are not even backed by credible sources and end up making losses. 

THE CRUX

There is no investment without risk existing in the finance world. Nevertheless, different investments come with different risks. When investors diversify the portfolio, they are essentially taking a big bunch of different risks that offset each other in order to provide stability to your investments. Failure to diversify a portfolio signifies you are taking the same risks. Putting all the eggs in one basket can make you potentially lose everything.