Everyday Money: What is Investment Diversification?

Having a diversified portfolio is one of the key principles to investing. Diversification is a risk strategy where money is spread out across different assets so that the risk in your investment portfolio is reduced.

Equity exposes your portfolio to market volatility. Fixed return investments give assured returns but often fail to beat inflation over the long term. By diversifying across a mix of equity, debt, gold, government bonds etc, risk of a market crash or inflation affecting your entire portfolio reduces.

Benefits of diversification

No asset class performs the same at all times. A particular investment will perform better than the others depending on the market conditions and interest rates regime. For instance, during periods of market volatility, as is the case from past one year, equity portfolio may suffer losses. Debt funds, which mainly invest in government securities, corporate bonds, treasury bills, are less prone to market volatility compared to equity funds. Fixed income securities and government bonds, on the other hand, are the safest when economy is slowing but give lower returns compared to equity.

By keeping a high percentage of your investment portfolio in one asset class, you risk losing more when that asset class is hit. By spreading out, risk in your investment portfolio will balance out because losses of one asset will be offset by the gains from others.

How to diversify?

You should plan diversification on two levels—across asset types and within an asset class.

There are broadly three asset classes—equity, debt and cash. Historical data shows that equity can deliver an average of 13 per cent over the long period of over seven years. But with high returns come high volatility risk. Debt shields against market volatility but may not be able to beat inflation in the long run. Cash, meanwhile, will ensure liquidity in the case of emergencies.

So, debt investments will mitigate losses that you may incur in equity whereas, equity have high growth potential and will make up for low returns from debt.

Within equity funds, you can diversify across different market caps—large-, mid- and small cap. Data shows that large caps have delivered better returns than mid and small cap in 2-3 years horizon, whereas mid-caps have outperformed large caps over 10-year investment period but are more risky than the former. So, as per your risk appetite, you can diversify across different segments. Similarly, debt options consist of sovereign bonds, government securities, debt funds and term deposits.