If anybody were to make an investment product for themselves, they will always want only 2 things low risk and high return.
However, achieving this is easier said than done. There is NO SINGLE investment that provides you with a high return by taking low risks.
All of us wish that our investments should only increase in value, but there will always be periods when some of your investments will lose value.
This is where diversification comes into play. Through diversification, you ensure that excess and unnecessary risk is avoided.
By putting your investments in different investment instruments you make sure that your diversified portfolio is not exposed too heavily to a company or sector.
In this post, we will explain to you
- What types of risks does your investment face
- How can you reduce the impact of stock market volatility
- How Time is crucial in diversification strategy
- Why having more than 1 fund investment is necessary
So, let’s get into it.
Different types of risk in financial markets
When investing in financial markets, investors face 2 types of risks. These risks are Market Risk and Company-specific risks.
Now, the Market risk is also known as un-diversifiable risk. This type of risk is applicable to all companies in a country.
Some examples of this risk are a sudden increase in inflation, political instability, war and pandemics. This risk can not be avoided and you must accept it.
The stock market crash due to coronavirus is a perfect example of Market Risk, stock markets across the globe fell. Global Stock Market lost US$7 trillion in the initial sell-off.
On the other hand, Company-specific risk is also known as diversifiable risk. This type of risk is concentrated in companies, sectors, industries.
The most common type of company-specific risk is business risk associated with any particular company. This risk can be avoided through diversification.
For example, if the government increases taxes and excise duty of petrol and diesel. Then the entire non-renewable industry will lose demand. Which will be reflected by a decrease in their stock prices.
The entire premise of diversification benefits is relied upon avoiding company-specific risks.
In simple terms, you can reduce only company-specific risk through diversification.
And you must diversify investments till the point you can justify the risks and accept the future returns by taking those risks.
Reducing the impact of market volatility
Stock markets are known to be volatile. And market volatility can be both good and bad. It is up to you when it comes to dealing with market volatility.
See, when investing we only have to worry about the downside volatility. As the upside volatility transforms into returns.
By staying diversified into fundamentally sound investments, you can limit the downside risks.
Valuing investments fundamentally and investing in multiple asset classes will always provide returns in the long run.
The primary purpose of diversification is minimizing portfolio risk. When investments in one asset class perform poorly, your investments in other asset classes can offset those losses.
For instance, having bonds along with stocks will provide your portfolio diversification benefits.
As bonds are relatively less volatile than stocks. In the long term, even though having bonds will slightly decrease your returns but will greatly minimize risks.
Factoring Time in Diversification Strategy
Most articles only tell you the benefits of diversification. But never put light on how diversification strategy has to be dynamic over the years.
You may be accustomed to thinking about investing in terms of financial goals like a vacation, buying a house, retirement plan. And it is right to think in these terms.
So, when it comes to diversifying your investments, you must factor your time horizon. As it is constantly changing and with it your risk tolerance also changes.
For example, let’s assume that your goal is having a retirement fund of ₹1 Cr. which is 30 years away.
As your goal is far away, your risk tolerance is also high. Because you have time to recover lost value in the event of a market shock.
So, your allocation in equity funds should be higher than debt funds to chase long-term growth. These funds are well-diversified with a growth objective.
Here, your diversified portfolio allocation can be 80% in Equity funds and 20% in Debt Funds.
Now, assume that your retirement is 10 years away instead of 30 years.
As your goal of a retirement fund is relatively close, your risk tolerance also reduces significantly. Because now you do not have time to recover any loss from a market shock.
So, your allocation should be reduced from high-risk equity funds to more conservative debt funds. Debt funds are also well-diversified with stability as its objective.
Here, your diversified portfolio allocation can be 40% in Equity funds and 60% in Debt Funds.
Now, assume that you have retired.
Your investment allocation should be more in relatively stable funds that generate some income. At this point in life, the biggest risk is outliving your assets. So you should also have some equity funds to beat inflation.
Here, your diversified portfolio allocation can be 20% in Equity funds and 80% in Debt Funds.
Never be 100% in Equity funds and never be 100% in Debt funds. A diversified portfolio is the foundation of a smart investment strategy.
You should take the diversification strategy to the next level. Diversify into 2 or 3 funds to ensure that you properly spread your investments in uncorrelated asset classes.
For instance, your major investments are in an index fund that mirrors a broad-based index like Nifty 50. And coupled with this you can invest a minority share in funds that have a varying risk level. These funds can be :
- Debt Funds
- Gold ETFs/ Funds
- Money Market Funds (Overnight Debt Instrument Funds)
- Funds that invest in foreign stocks
- Small-cap funds (if you are seeking aggressive returns)
- Real Estate Investment Trusts
When invested in more than 1 fund, you make sure that your investment is spread across different asset classes. Each of the above-mentioned funds will perform differently under different market conditions. Here are 6 advantages of Mutual Fund investing.
For instance, assume that you had a diversified portfolio that consisted of 50% Nifty Index Fund (equity investment) and 50% of gold ETF (gold investment).
In the current corona crash, your losses in the Nifty Index Fund would be reduced by your gains in the gold investment.
By investing in 2 or more different type of funds, it more likely that at least one investment will perform well at any given time.
You should always remember that risk can never be completely eliminated. All you can do is to reduce it if you play your cards the right way.
Through diversification, you can manage risk and reduce market volatility. All diversification does is that it reduces the risk associated with single companies.
A smart approach for individual investors like you is that invest in top mutual funds of different kinds. You’ll automatically be diversified into different assets and your work here will be done.