Real diversification comes to a portfolio if investments are allocated to different asset classes keeping in mind the correlation between them.
When people seek advice on investing, they are often told that ‘diversification’ helps. What does diversification mean? We have often heard the common saying that one should not keep all eggs in one basket. Similarly, instead of investing all your money in the same fund or a single stock, you should try to invest in diversified investment avenues to minimise risk in your overall portfolio.
“Real diversification comes to a portfolio if investments are allocated to different asset classes keeping in mind the correlation between them, such as equity, bonds/debt fund, gold, property, etc,” says Anjaneya Gautam, National Head - Mutual Funds, Bajaj Capital.
Understand the type of diversification
There can be both diversifiable and non-diversifiable risks in your portfolio. Diversifiable risk is an unsystematic risk, which means the risk can easily be varied or minimised by applying a certain strategy, for example, your mid-cap funds-heavy portfolio can be restructured to add some large-cap funds or by switching from some of the risk funds to a better one. Whereas the non-diversifiable risk or the systematic risk cannot be changed and the occurrence of such risk is natural, for instance, the volatility in the market.
If you buy many funds, you are exposed only to movements in that market. But if you buy a single fund, then you are exposed to both - market movements and poor performance of the fund based on its underlying company. In such a case, it is diversifiable because it can be reduced by diversifying among funds.
How does diversification help in minimising risk?
Diversification helps in minimising the risk but it should be applied strategically because it can lower your portfolio's return below what it should be.
If the entire portfolio were invested in the same asset class, for instance, if you have five different debt funds then such a diversification in number doesn't guarantee that your risk will be minimised and would lead to higher returns. You should aim for different asset classes.
Therefore, the presence of more asset classes in a portfolio leads to greater diversification benefits, i.e. lower risk of exposure to loss.
“If you want to truly diversify your portfolio, then you need to invest in such stocks/funds that are not correlated to each other in performance. You can do this by considering which asset holdings your current fund has and based on that try to spread your money so that no asset with similar features are repeated in your next fund,” said Abhinav Angirish, Managing Director, Abchlor Investment Advisor.
Dhaval Kapadia, Director, Portfolio Strategist, Morningstar Investment Advisers told Moneycontrol that diversification is a way of dealing with the unpredictability of future events. Allocation across various asset classes, such as equity (domestic & international), fixed income, gold, cash, etc. helps to achieve a feasible combination of risk and reward that is consistent with an investor's specific situation and goals.“It puts the principle of diversification to work so that when some asset classes are experiencing a downturn, others may be experiencing stronger performance given less than perfect correlation between asset classes,” he said.