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Why Is Portfolio Diversification Important?

Financial Market comprises of a variety of financial instruments and investment vehicles that you can choose from. You need to understand which financial instruments suit your financial goals the best. Your portfolio diversification depends a lot on the type of instrument you are looking for and the amount of profit you wish to make. Financial experts always advice that one should never put all the eggs in one basket; This means that buying only one stock and anticipating continuous profit from the same is not realistic.

Investors need to have a diversified portfolio so that when one stock or sector crashes, the other stocks make up for the loss by earning higher returns. Since, the financial market is never completely predictable, diversification helps in earning desired returns. Here are few such reasons which make portfolio diversification crucial for your investment.

  1. Reduces The Risks:

Every stock or financial instrument carries some amount of risk with it except the risk-free However, the risk is good when you can manage it according to the level of returns you are expecting. When an investor is young, he or she can take the risk because of the time they have in hand. They can invest in risky financial instruments on a long-term basis to earn higher returns. However, in the case of an investor who is nearing retirement, an excess of risk might damage his returns as the term left for the maturity of the investments is short. With portfolio diversification, one cannot completely remove the risks but can reduce it to a great extent. Without proper diversification amongst the different classes of the assets, the risk of investment rises with every investment you make. One needs to include both risky asset classes such as high- return generating stocks and to mitigate their risk they should invest in fixed income assets. Diversification gradually reduces the risk of the portfolio over time.

  1. Helps In Hedging:

In the last few years, investors with complete equity portfolios have seen lows of all time due to the excessive volatility in the market, and thus their returns also dropped significantly. However, if they would have kept a certain amount of other investment assets like commodities, bonds, metals in their portfolio, their profits would have been higher. Diversification helps in achieving desired or better returns even when the market is slow as there are other markets which make up for the negative or low yields of the former market. In this case, the loss or low profits of the equity market would have been wiped off by the positive returns of the commodities market. This way investors can hedge their investments and earn potential returns through portfolio diversification.

 

  1. Provide Higher Returns:

Since the market keeps on changing its course, you need to diversify with asset classes which are not correlated. Correlation plays the most critical role in determining your returns. If you are investing in one market which is connected to the other, when the former goes down, that will substantially affect the other. You need to choose investment vehicles which are entirely different from each other. For example, if you are young and have 60% of your investments dedicated to equities, the remaining 40% must be allocated in assets which do not have any positive correlation with the stakes. Alternative investments can be one such investment vehicle, commodities being the other. When the correlation is negative between two asset classes, if one asset class is performing slowly or providing a negative return, in most cases, the other asset will bring in positive gains and the losses will be squared off. If you make calculated and planned investments in different markets you will not only reduce your risk; you will also earn a comparatively higher return.

  1. Aligning Your Portfolio With Your Financial Aspirations:

As per the Behavioural portfolio theory, either your investment will give you the potential for high-growth, or it will protect from negative returns. This theory states that when a portfolio is diversified, it corresponds to a pyramid structure. A properly diversified portfolio has the maximum of low-risk investments and provides value growth and steady income generation. ‘Blend’ funds comprise the top of this pyramid which is a mix of risky and low-risk investment instruments. Along with these funds, there are growth stocks and this combination allows you to align your financial aspirations with your investment. The regular income generating investments will provide with periodic income, and the blend funds will grow in value, and together they bring stability of investment and higher wealth accumulation.

  1. Investment Mix Adjustment:

Portfolio diversification allows you to modify your investment mix as per your changing financial needs and market changes. With age, the investment mix also needs to be changed as the tenure for investments keeps on reducing. While you start off with high-risk investment instruments, with time flowing, you must reduce your risk by shifting more towards fixed income financial instruments for regular earnings. While an investor of 20’s age group can assign 90% of his investment into stocks, investor of 50’s age group must have not more than 40% allocated to equities. So, when you have a diversified portfolio, you can keep on changing the assets and investment mix with as per the time in hand and your personal financial goals.

    Upholds Capital:

Investments made by people are not always with the same intentions. While some of the investors who love risk and are looking for higher returns would go for investment vehicles which provide them capital appreciation, others who like to earn regular income and preservation of capital would opt for less risky Whatever individual investment strategy you have in mind, it can be achieved through portfolio diversification. Diversification helps in upholding your wealth when the rate of return is secondary for the investor.

Hence, portfolio diversification offers many advantages to the investors. It is appropriate for both kinds of investors whether they are risk-averse or risk-takers. It is necessary for young investors as well as the prudent and experienced investors. It not only helps in minimising the risk of investments but also helps in conservation and appreciation of capital.

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