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Fruit stand and the need for diversification

ICICIdirect 8 Mins 16 Jun 2023

In one of our previous blogs, we discussed financial planning in detail. If you have read the article, you will know that one of the crucial parts of financial planning is creating a diversified portfolio.

Most investors assume they know everything about diversification. Not true. There are many layers to it. Most investors only know the top few. We request you to stay focused on the article so we can help you understand all layers of diversification.

What is diversification?

The basic rule in investing and elsewhere is that you should never keep all your eggs in the same basket. Diversification is a strategy of spreading your investment across different asset classes to reduce your risk. The asset classes range from stocks to bonds and even cover real estate. The idea is that you should not invest all your money in one asset class. For example, you should not invest all your money in large-cap funds.

Fruit stand and the need for diversification

As mentioned above, the primary reason you should have a diversified portfolio is to reduce your risk. Let us understand diversification with an interesting example.

Which fruit business would you prefer to start among the below three?

  • Kiwi business - that comes with high-profit margins.
  • Bananas - they are available easily, but margins are less.
  • Fruit stand - with all the fruits?

The obvious answer should be option 3. When you open a fruit stand business, you have a safety net. During some months, if the availability of apples goes down, your business can still flourish by selling other fruits. There will always be some fruit where your profit margins will be high, which ensures you are in profit at the end of the day.

If you only depend on Kiwi, and the Kiwi does not come into the market (for some reason), you are in trouble. 

Let us see how diversification helps you in your investing journey. If you have a gold investment, it must be giving excellent returns (oranges) even though the equity (apple) is performing average. If you need funds today, you will have some investments to sell in profits. 

A word of caution

Understanding diversification properly is essential. There is a thin line between diversification and over-diversification in investing portfolio. You should not overdiversify your portfolio. If you start selling all the available fruits in the market, it will not be good for your business. In fact, it may cause harm sometimes. You may not be able to sell some fruits as demand is not good in your area. Fruits start to deteriorate after some days - you end up at a loss.

Similarly, you have the freedom to pick any asset class to invest in, but you should carefully select your asset class. How? 

How do you diversify your investment portfolio?

Now that you understand the need for diversification, let us discuss how you can do it. Here are a few things to do to diversify your portfolio:

  1. Set clear investment goals: Before diversifying, define your investment objectives, time horizon, and risk tolerance. It will guide your investment decisions and help you determine the appropriate asset allocation.
  2. Understand your risk tolerance: Assess your willingness and ability to take risks. It will influence the mix of investments you choose for your portfolio. Generally, riskier investments have the potential for higher returns but also come with increased volatility. For example, if you are a conservative investor, you should not invest in small caps. If you do, the percent allocation should be lower.
  3. Allocate across different asset classes: Invest in different asset classes, such as stocks, bonds, cash equivalents, real estate, commodities, and alternative investments. Each asset class has its return and risk characteristics. Also, their performance can be influenced by different economic factors.
  4. Diversify within asset classes: Diversify further by investing in different instruments within each asset class. For example, if you invest in stocks, consider spreading your investments across various industries and companies of different sizes. Similarly, if you invest in bonds, diversify by investing in different issuers, maturities, and credit ratings.
  5. Consider geographic diversification: Expand your portfolio's reach by investing in assets from different countries and regions. Economic conditions and market cycles can vary across countries, so having exposure to multiple markets can help mitigate risks associated with specific regions.
  6. Research and analyze investments: Conduct thorough research and analysis before making investment decisions. Evaluate factors such as historical performance, financial health, management expertise, market trends, and future growth potential.

Before you go

Diversification does not guarantee profits or protect against losses, but it can help manage risk and enhance the potential for long-term returns. 

If you have just started your investment journey, please take care of the above points and create a diversified portfolio. 

If you have an existing portfolio, we want you to put in some effort. Look at the stocks, mutual funds, and other assets (if any) and see if your portfolio is diversified. If it is not, work on your portfolio and make it diversified. Please note that you don't have to take extreme steps (sell everything and create a new portfolio). Diversification can happen over time - all you need to do now is start.

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