Why Do Investors Diversify? How Asset Allocation Can Change the Way You Build a Portfolio

What Is Diversification?

Portfolio diversification consists in distributing one's investments among a variety of assets or investments.

For instance, rather than putting the whole of their portfolio into technology shares, an investor might hold shares from various sectors as well as other types of assets.

The concept is simple, in that different investments can react in different ways to the same market event.

When one sector does well, another might do relatively better. In the same way, an asset class which is under pressure in one market situation may act differently in another.

It does not follow that diversification will ensure a profit or that it will completely guard a portfolio against losses.

What Is Asset Allocation?

Although diversification is about spreading out investments, it is asset allocation that decides how much of your portfolio should be invested in various asset classes.

Common asset classes include:

• Equity
• Debt or fixed-income investments
• Gold
• Cash and cash equivalents
• Real estate and other assets

For instance, an investor might choose to assign part of their portfolio to equities, another part to debt and a smaller amount to gold.

There is no asset allocation that can work for all people.

The correct proportion will vary according to factors including age, financial objectives, investment horizon, income, liquidity requirements and risk tolerance.

Why Does Asset Allocation Matter?

Various asset classes have their own characteristics.

While equities have the potential for long-term growth they can also be subject to considerable short-term volatility.

Debt-oriented investments may offer comparatively different risk and return characteristics.

Gold can act in a different way to that of equities and is therefore often seen as contributing to portfolio diversification.

At the same time, Cash supplies the liquidity needed for short-term requirements.

Investors will be able to construct a portfolio more in line with their financial goals by combining a variety of assets rather than depending completely on the performance of a single market.

Diversification Does Not Mean Buying Everything

It is a widespread misconception that holding a large number of stocks automatically results in having a diversified portfolio.

It doesn't necessarily.

Let's imagine that an investor holds 20 stocks but 15 of these are in the same sector; in that case, the portfolio could still be exposed to a high degree of concentration risk.

Just as having a number of funds which invest in the same companies could give the impression of greater diversification than it actually does.

What counts in effective diversification is the range of your holdings, not just the number of investments you have.

How Can Investors Diversify?

There are a number of methods available to investors who wish to achieve diversification.

Diversify Across Sectors

Rather than focusing solely on one sector, investors might look at companies that operate in various parts of the economy.

For instance, the sectors of banking, healthcare, technology, the production of consumer goods and energy can differ in their reactions to economic conditions.

Diversify Across Asset Classes

Investors have the option of distributing their investments among equities, debt, gold and other appropriate asset classes.

It is here that asset allocation becomes especially important.

Diversify Across Companies

By holding investments in a number of different companies, the effect of any one company's poor performance on the entire portfolio can be reduced.

Yet investors ought to assess each investment rather than just adding shares in order to boost the number of holdings they have.

Diversify Across Time

Investors might also think about the way in which they allocate their capital over time.

A systematic method of investing can help investors from making the full investment depending on a single market level, even though it does not eliminate market risk.

What Is Rebalancing?

It is not essential that asset allocation be a one-off decision.

Let us imagine that an investor initially decides to assign 60% of the portfolio to equities and 40% to all other assets.

Should equity markets rise considerably, equities could at some point make up 70% of the portfolio.

The present allocation in the portfolio has departed from the investor's original plan.

Rebalancing means looking over the portfolio and then restoring the allocation to align with the desired mix, in accordance with the investor's strategy.

The frequency with which rebalancing is done and the method employed may differ. Before deciding to make any changes, investors should take into account the taxes, transaction costs and their own particular situations.

How should people who are just starting out consider risk?

It does not follow that the correct portfolio is the one which offers the highest possible return.

It is the one which an investor could reasonably remain invested in throughout various market conditions.

If a portfolio is that aggressive then the investor might panic and be led to sell all their investments as a result of a market correction and in that case the original allocation could have been inappropriate for that investor.

That is why it is important to take risk tolerance into consideration together with expectations regarding return.

Before choosing an asset allocation, investors can ask:

• What would I like to achieve with my investment?
• When is the money going to be needed by me?
• How much volatility are you able to tolerate?
• Is it necessary for me to have regular liquidity?
• What proportion of my portfolio is currently invested in one sector or asset?
• Does the way I have my funds allocated correspond with my financial goals?

Building a Diversified Portfolio With Dhanush by Ashika

Investors who use Ashika's Dhanush 2.0 will be able to access a variety of investment and market-related products via a single digital ecosystem, provided that they meet the relevant eligibility and account requirements.

The platform gives investors access to a range of products and features that vary by market segment so that they can carry out research and manage their investments in accordance with their own objectives.

But diversification is not about using every product available.

The goal is to understand each investment, assess its risk and decide whether it fits within your overall portfolio.

The Bottom Line

Diversification and asset allocation are two important concepts for building a portfolio.

Diversification helps reduce dependence on a single investment, company, or sector, while asset allocation determines how you distribute your money across different asset classes.

Neither approach can guarantee returns or eliminate losses. But a well-considered portfolio can help investors manage concentration and align their investments with their goals, time horizon and risk tolerance.

Instead of asking, “Which investment will perform best?”, investors can also ask:

“How should my overall portfolio be positioned for different market conditions?”

That shift in thinking can be an important step towards building a more balanced investment approach.