Portfolio diversification is the key to building a profitable portfolio. Such a portfolio helps an investor achieve long-term growth out of their investment. Asset allocation greatly depends on investment goals and risk tolerance. Talking about diversification, there are certain things to keep in mind but first, let’s talk about risk. Risk is one thing that concerns an investor the most. He/she is worried about the money they put in an asset and if they are guaranteed a return out of that asset. Risk is the possibility of the downside of an investment made because it is related to returns. Some securities like bitcoin, cryptocurrency have greater risk associated with them hence returns are greater too. Similarly, stocks, do have risk involved, but the returns generated are higher too.
On the other hand, low-risk assets like bonds are considered safe but have a lower return too. These assets are essentially risk-free but also come under fixed-income securities. Therefore, we can say stocks have some risk relatively but with higher risk comes more return too. Young investors in their prime age bracket 20-40s generally have a high-risk investment strategy because they would want to maximize returns and they can overcome losses if any occur. However, a person near retirement age would want to invest in assets that would give a consistent return
Coming back to diversification, it is considered immensely important to manage risk. Hence a clever investor will keep balance across three major categories when building a portfolio. They are as follow:
1. Balance across the type of assets: It is rightly said ‘Don’t put all your eggs in one basket. Adequate quality and focused assets in your portfolio will have an investor reap benefits for years. A worthy portfolio can have a combination of low risk, fixed-income securities like bonds, cash, or gold (for example 10-15% of the portfolio) so that there is surety of income, and with the remaining (example 85-90% of the portfolio), investors can have an aggressive approach by investing in stocks and take upon some risk associated. But the question here arises which stocks to invest in? The answer lies in investing in stocks that will reduce risk but provide greater returns. Stock performance is mostly evaluated through financial analysis, growth trajectory, and market conditions or macro factors therefore one must keep all these factors in mind when making decisions regarding investing in stocks.
2. Balance across the size of the firms: Investments should be made in both small and large firms. The growth trajectory and long-term goals of the company are considered before investing. Investing in big-sized, well-settled companies doesn’t need much explanation. These companies are more stable, so consistent dividends are guaranteed. Also, investors can predict future goals and directions of the firm. At the same time investing in small size, companies can also help maximize overall benefits since these companies have the potential to give higher returns as compared to other big-sized companies which grow slowly, however with some risk involved. So, an investor can allocate parts of their investment portfolio to each type of stock so there are opportunities for big profits and stability too.
3. Balance across the type of industry: It is important to keep in mind to invest in companies that will benefit the investor in different sort of macro environment changes that will happen in the future. Industry diversification is, in fact, the key to maximizing benefits out of your portfolio. To take an example, if there is an interest rate fluctuation announced as a monetary policy by the government, then there should be companies in your portfolio that could benefit its investor due to changes in interest rate. For instance, banks. They do well when the policy rate goes up however other companies are adversely affected in terms of paying more as interest payment hence cost of financing rises. Another example could be a change in oil prices. Not only will this affect oil stock prices, but it will also have an impact on transportation-related companies. These companies will gain or lose profitability accordingly.
To sum it up, a diversified portfolio will comprise a mixture of investments. This not only helps an investor manage risk but also reduces the impact of volatility of price movements on portfolios. This diversification requires time and consistency, however, it is hard to find assets that aren’t correlated but with market research even new investors can mitigate risk for any given return.