What is Diversification? – Key to High Return on Investment

Before we get started on what is diversification let me tell you a short story.

When I was five years old, my family and I were on our way to my native place to attend a wedding. Before starting the journey, dad asked my mom to diversify the money and keep it in different bags. So in case of theft, we didn’t lose all the money.

That was my first lesson on what is diversification.

So, when I heard the term diversifying your investment, the concept was pretty clear. Divide your money across various investment options to reduce risk.

In this article we cover:

1. Why is diversifying your portfolio important?
2. How can you diversify across different asset classes?
3. How much should you allocate towards each asset class?
4. How to tell if your portfolio is well diversified?

what-is-diversification

Why Is Diversifying Your Portfolio Important?

Let’s take an example. Meet two best friends, Mr. Flex and Mr. Stiff. Both works at the same place but have different eating habits.

Mr. Flex prefers eating a balanced diet which includes dal, veggies, and rice. Whereas, Mr. Stiff only has pizzas for every meal.

Because of a balanced diet, Mr. Flex manages to lead a healthy life. Whereas, Mr. Stiff eventually became obese.

This pattern was repeated in their investments as well. Both of them had Rs 1 Lakh to invest. Mr. Flex decided to diversify his investments across different asset classes. Whereas, Mr. Stiff only invested in Fixed Deposits.

Mr. Flex’s Diversified Portfolio:

  • Rs 10,000 in Fixed Deposits
  • Rs 45,000 in Shares
  • Rs 25,000 in Mutual Funds
  • Rs 20,000 in Gold

Mr. Stiff’s Non-Diversified Portfolio:

  • Rs 1 Lakh in Fixed Deposit
Mr Flex’s Rs 1,00,000 Returns after 2 years Principal + Returns Mr Stiff’s Rs 1,00,000 Returns after 2 years Principal + Returns
Rs 10,000
Fixed Deposit
5 % per annum Rs 11,025 Rs 1,00,000
Fixed Deposit
5% Rs 1,10,250
Rs 45,000
Equity Shares
20% Rs 64,800
Rs 25,000
Mutual Funds
17% Rs 34,222
Rs 20,000
Gold
8% Rs 23,328
Total Rs 1,33,375  Rs 1,10,250

*Equity shares returns are based on BSE Sensex returns in the last two years. 

*Mutual funds returns are based on the average performance of equity large-cap funds.

As you can see. Mr. Flex diversified his investment and earned more than Mr Stiff just by making a smart move.

When you invest your money in different assets, you reduce the overall risk to a great extent and maximise returns. Whereas if you dedicate your money to a single asset and it underperforms, there is nothing else to compensate for the loss.

Hence diversification is a must while investing.

How Can You Diversify Across Different Asset Classes?

When you build a portfolio, think of it as if you are building a cricket team. If you have a team of only eleven batsmen, No bowler. Will you win the match?

Absolutely Not!

A great team has a balance of batsmen and bowlers.

The same rule applies to your portfolio. You must invest in asset classes which are different from each other. These can include:

1. Equity shares

Investing directly in shares of listed companies is a great investment option for investors with high risk appetite. But even in shares, you can diversify across different sectors such as:

  1. Banking
  2. Technology
  3. Energy
  4. Metals and Mining
  5. Pharmaceutical

To explore more about equity shares – Click here.

2. Bonds and Debentures of Companies and Government.

Bonds and debentures are a form of fixed income securities. It is an ideal investment option for low risk investors. They offer you a fixed income and you get the principal amount on maturity. You can club a high-risk investment like shares with a moderate-low risk investment such as bonds and debentures to reduce overall risk.

To explore more about bonds – Click here.

To explore more about debentures – Click here.

3. Mutual funds

Mutual funds are self diversified. When you invest in a mutual fund, the fund manager will invest the collected corpus in various stocks or bonds or both. For example, if you invest in an equity mutual fund scheme, you are buying units of different stocks in different proportions.

Here is an example of Axis ESG Equity Fund.

Holdings % Weight Value
Avenue Supermarts Limited 9.92% 190.250 Cr
Bajaj Finance Limited 8.19% 157.059 Cr
Tata Consultancy Services Limited 7.64% 146.395 Cr
HDFC Bank Limited 7.08% 135.718 Cr
Nestle India Limited 6.95% 133.179 Cr
Wipro Limited 6.74% 129.278 Cr
Housing Development Finance Corporation Limited 6.14% 117.653 Cr
Info Edge (India) Limited 6.12% 117.383 Cr
Kotak Mahindra Bank Limited 4.84% 92.700 Cr
Torrent Power Limited 3.52% 67.543 Cr
HDFC Life Insurance Company Limited 2.92% 55.891 Cr
Microsoft Corp 1.39% 26.650 Cr
Alphabet Inc A 1.30% 24.962 Cr
Symphony Limited 1.09% 20.831 Cr
Recruit Holdings Co. Ltd 0.97% 18.660 Cr
Booking Holdings Inc 0.93% 17.861 Cr
Assa Abloy Ab 0.91% 17.498 Cr
Schneider Electric SE 0.89% 16.999 Cr
Texas Instruments Inc 0.89% 16.997 Cr
Taiwan Semiconductor Manufacturing Co Ltd 0.87% 16.665 Cr
Roche Holding Ltd 0.85% 16.210 Cr
Bunzl PLC 0.83% 15.940 Cr
ASML Holding NV 0.81% 15.606 Cr
The Toronto-Dominion Bank 0.81% 15.576 Cr
First Republic Bank 0.80% 15.336 Cr
Banco Bilbao Vizcaya Argentaria 0.80% 15.334 Cr
AIA Group Ltd 0.77% 14.816 Cr
Thermo Fisher Scientific Inc 0.77% 14.702 Cr
Tencent Holdings Ltd 0.77% 14.688 Cr
Bank Central Asia 0.76% 14.632 Cr
Visa Inc 0.76% 14.625 Cr
Nestle Ltd 0.76% 14.595 Cr
Vertiv Holdings Co 0.75% 14.442 Cr
Trane Technologies Plc 0.73% 13.901 Cr
Unilever PLC 0.72% 13.840 Cr
Unitedhealth Group Inc 0.71% 13.529 Cr
Anthem Inc 0.70% 13.341 Cr
Sona BLW Precision Forgings Limited 0.61% 11.763 Cr
Adobe Inc 0.60% 11.590 Cr
Vestas Wind Systems AS 0.56% 10.788 Cr
Mastercard Incorporated 0.56% 10.749 Cr
Adidas 0.55% 10.528 Cr
Kerry Group PLC 0.53% 10.128 Cr
Kingfisher PLC 0.49% 9.386 Cr
Xylem Inc/NY 0.47% 8.952 Cr
Raia Drogasil 0.42% 8.062 Cr
Dexcom Inc 0.38% 7.349 Cr
Tomra Systems ASA 0.34% 6.493 Cr
Spirax-Sarco Engineering PLC 0.32% 6.147 Cr
Greggs PLC 0.30% 5.798 Cr
Oak Street Health Inc 0.22% 4.299 Cr

Source: Data as of 16th June 2021

Similarly, you can invest in different types of mutual fund schemes:

  1. Equity funds
  2. Hybrid funds
  3. Debt funds
  4. Money market funds
  5. Growth funds
  6. Value funds
  7. Sectorial funds
  8. Thematic funds
  9. Exchange Traded Funds (ETFs)… and a lot more.

But, you must optimise your returns by investing in different mutual fund schemes with assets that are not correlated.

Watch this Mutual Funds video for a better understanding:

4. Gold

Allocating a portion towards gold is always a good idea as it acts as a hedge against inflation. But investing in physical gold is not a good idea as its making charges are too high. Instead, you can invest in gold ETFs or Sovereign Gold Bond (SGB) Scheme offered by the Government.

SGBs provides you 2.5% annualised interest rates + capital appreciation as well.

5. Bank Fixed Deposits, Post Office Saving Schemes, National Saving Certificate

These investments are ideal for risk-averse investors as they are very safe. But the interest earned on these investments are barely able to beat inflation. So, you can club these investments with different asset classes to make the most out of your portfolio.

Investing in NSC is a good idea to save taxes. They provide deductions up to Rs 1,50,000 under section 80C of the Income Tax Act.

With a well-diversified portfolio, you get two main benefits.

  1. Risk mitigation
  2. Capital preservation

These help in improving the overall portfolio return.

Now The Question Arises, How Much Should You Allocate to Each Asset Class?

what-is-diversification

Asset allocation depends on four major components.

1. Risk Appetite

When it comes to investing your hard earn money, you must determine how much risk you are willing to take to earn higher returns. If you can afford to take high risks and be patient during short term fluctuations, then high-risk investments are suitable for you.

Whereas, if you are a risk averse investor and capital preservation is your first goal, then low risk investments are ideal for you.

High risk Medium risk Low risk
Tenure  10 years + 3 – 5 years 1 – 3 years
Risk-Reward ratio High Moderate Low – Moderate
Investment options  Small-cap, mid-cap and large cap stocks Large-cap mutual funds, balanced funds, debentures Government bonds, government schemes, Bank Fixed deposits, liquid funds

2. Return requirement

According to your risk appetite and the investment option you choose, your return also varies.

  • If you invest in a high risk investment option, then you earn high returns.
  • If you invest in a low risk investment option, then you earn low returns.

3. The time horizon of your investment

You must decide for how long you are willing to hold the investment. For example, you have a high risk appetite and you decide to invest in stocks. But if you don’t hold it for an adequate period of time then it won’t work for you. High risk of stocks is neutralized only when you hold them for a longer time horizon.

So defining your holding period is a must.

4. Age

Diversification across asset classes needs to change with your age. When you are young, you can choose to be more aggressive to grow your wealth. On the other hand, as you grow older, you must focus on preserving wealth and hence choose medium-low risk investment options.

How to Tell If Your Portfolio is Well Diversified?

A well diversified portfolio should look like a Christmas tree. More green and less red. It is very obvious that when you invest in multiple investment options, they may perform differently. So, not all your investment options will be profitable. But if any of your investment is underperforming at the moment, the loss will get compensated with the profitable investment option. So, diversification does provide a cushion for your investments.

But many times investors who have experienced the harmful effects of under diversification mistakenly believe that more diversification is better. That’s not true. Over diversifying your portfolio by adding too many stocks or too many mutual funds of the same type is not a good idea. Hence, you must make a conscious choice of selecting diverse asset classes which are uncorrelated.

But, selecting the right mix is hard. Don’t worry as we have found a way out. The answer is investing in mutual funds. It offers an inexpensive way of diversification.

You can easily diversify your portfolio at a broad level by investing in an multi asset fund or a dynamic fund which invests in equity mutual funds and debt mutual funds.

By doing so you are dedicating a chunk of portfolio towards low risk investment option and a chunk towards high risk investment option.  So, you will be able to reap maximum benefits with medium to low risk.

But choosing the best mutual funds is not easy. Retail investors do not have the time nor the resources to analyse mutual funds. Hence, RankMF has come up with the list of best mutual funds in India after analysing over 20 million data points!

RankMF also provides goal based investment baskets. These baskets are well diversified. You can invest according to your goals. Such as tax saving basket, retirement focus basket, risk appetite and time horizon basket and a lot more…

RankMF rates and ranks all mutual fund schemes in India. It also provides the most honest answer to, kaunsa mutual fund sahi hai? So, RankMF is the ultimate one-stop shop for you!

Open a FREE RankMF account today and start diversifying your portfolio!

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