Diversification is an important method to reduce risk when investing. There are two types of risk involved when investing: an un-diversifying risk and the other is being diversifiable risk. Un-diversifying risk is also called systematic risk and is a part of every industry, such as Inflation rates, the political climate, interest rates, war, and other risks which cannot be mitigated. On the other hand, diversifiable risk deals directly with an individual and market and can be reduced by diversifying. It is important to note that the financial risk associated with each property varies.
What is portfolio diversification?
Portfolio diversification can be defined as the process of investing your money in different asset classes and security options to minimize the overall risk of investment. Consider an example of investing entirely in just one form of investment, and everything will be fine as long as the market is good. In case the market falls, all your investments will be at a loss.
The different class of assets available for investment includes stocks, funds, bonds, commodities and real estate. By investing in shares, you will be able to provide yourself with a regular dividend and interest. However, investments in shares can be the riskiest and volatile investment as the stocks’ value can go up and down anytime and because it is not predictable.
Real estate is another widespread form of investment whereby investments are made on the property, and the value of the property always tends to appreciate. Real estate is also a preferred form of investment as it provides investors with lucrative returns. Real estate also has several options such as self-owned property, property for leasing and rental purposes, etc. You can also invest in commercial or residential property types, depending on the market you chose to invest in. Investment in real estate can also help in times of need as you may avail of loans by mortgaging your property or selling off the property.
How does Diversification help in mitigating risk?
The main reason for the Diversification of the portfolio is to reduce the exposure to risk during investment. In this context, a common saying is “Don’t put all your eggs in one basket”,, which means one should not bank on just one type of investment to create wealth. It can also be stated that if an individual puts all his eggs into a single basket, there are chances of it breaking in case anything happens to the basket. Thus it can also be stated that investing in just one kind or type of industry can expose you to higher risk as your entire portfolio can be under threat in case of a recession, business closure, or market decline.
Different markets respond differently to the same situation as a recession or economic activity. For example, during a pandemic, stock markets were highly volatile globally, whereas real estate reacted slowly. In that situation, if you had only invested in stocks, the damage would have been higher, whereas if you had invested in real estate along with stocks, the damage would have been considerably less. The impact of risks on each investment varies, and hence it is better to place your eggs across different baskets.
The diversification process is important to mitigate risk associated and is an excellent way to improve and develop your investments. If you invest in different investment options, there is a higher chance of you being able to earn lucrative returns on some of your investments. The golden rule of investment is to hold on to long-term assets, yielding you returns even after five or more years of investment.
How to diversify your portfolio?
Some of the common ways of diversifying your portfolio include:
Asset allocation can be carried out by identifying the different modes you need to invest in to earn a better return. You may allocate funds based on specific percentages such as 40% in stocks, 50% in real estate, and 10% in mutual funds. ETF and mutual funds are also common choices for investors willing to diversify their investment portfolio to reduce the risk associated with it. It is also essential to vary the size of your investments to mitigate and eliminate unnecessary risk.
Consider Index, Fixed return or Bond Funds
You may also add an index fund or fixed income fund to your investment profile. Adding some form of fixed income solutions, you may also hedge your portfolio against market volatility and uncertainty. These funds match the performance of the broad indexes as they reflect the bond market’s value. Investing in index bonds or bond funds comes with low funds compared to the other modes of investment. Thus the management fees and the operating cost is minimal. In the case of rental property investments, you can also have a fixed income or a fixed return on your investment.
Know when to get out
One of the most important pointers in investing for return is knowing when to sell and when to invest. The “buy and hold” strategy becomes important for long-term assets. You must invest when the asset’s cost is low and sell when the asset’s demand arises and the supply is low. By doing so, you will be able to maximize the amount earned using your property.
Investing in Foreign Assets
You may also invest in foreign assets to diversify your portfolio. Financial experts also recommend investing at least 10% in foreign markets as the Indian markets are richly valued in recent times.
While diversifying your portfolio, it is also important to ensure that you do not over-diversify and select your broker effectively. It would be best if you did not over diversify because it is not a complete bulletproof jacket, and you will not be free from risk by 100%. By diversifying, you may also reduce income. As already stated, the right broker’s selection can help you mitigate the risk of both under and over-diversification.
Assetmonk is an online investment platform providing real estate investment assistance in India’s major cities, including Bangalore, Hyderabad, and Chennai. Assetmonk offers safe investing and rewarding properties in terms of capital appreciation and a better lifestyle.
Frequently Asked Questions on Portfolio Diversification to reduce risk:
The process of investing in different investment options instead of just one option is called portfolio diversification.
It would be best if you diversified your portfolio to avoid risk. Investing in just one option can expose you to higher risk if the value of the asset depreciates.
The investment philosophy is the set of beliefs, practices, etc., which influence an investor’s decision-making. There is a relationship between portfolio diversification as it is a better investment practice because it reduces the risk of investing. Diversification is a robust process of strategy and a source of alpha.