What is diversification: how and why should you do it?
28 Jun 2021 - Contact Sayan Sircar
Portfolio Construction
Diversification is spreading risk across various investments so that all of them don’t perform equally bad (or good) at the same time
Updated: 19-Apr-2022
Table of Contents
Introduction
Diversification implements the saying “don’t put all your eggs in the same basket” to investing. By diversifying, you allocate investments across various types of asset classes like stocks, bonds, gold, real estate across various countries and issuers (governments, corporations and others).
We see that the portfolio rises and falls at a rate lower than the individual components since it has two assets that do not rise and fall at the same time. The overall drawdown is lower than that of the constituents.
By diversifying, you are reducing the risk that all investments do not start falling (and conversely rising) at the same time. Diversification reduces the risk of the portfolio and if constructed carefully, will not reduce returns.
Diversification comes from two concepts:
- source of risk
- investment in low or uncorrelated assets
Each type of investment (e.g. a company) has two sources of risk:
- unsystematic - a company’s own performance and its perception in the market
- systematic - inherent risk in the entire country’s stock market
Diversification reduces unsystematic risk not just across various companies but across different asset classes as well until only systematic risk remains. For example, by adding more and more different types of assets, the risk decreases as in the table above.
Diversification is the only concept in finance where you get a “free lunch”. If different assets (measured by correlation) move in different directions simultaneously, and overall each asset moves up with time. If you combine this concept with rebalancing, you have a framework that allows you to buy low and sell high consistently. Diversification is one of the axioms of personal finance?.
How to diversify
As this table shows, different assets perform differently at different times. It is difficult to predict in advance which asset class wil perform better next so we will invest a little in each.
For Indian investors, diversification can be done by choosing
- domestic equity funds
- domestic debt funds
- gold funds
- investments in real estate (residential / commercial)
- international mutual funds
We will deal with the various allocations and returns in future posts.
Related reading:
- Why you should not consider investing large proportions in sectors or themes is explained here: What does the 1983 World Cup win teach us about investing?
- Portfolio construction basics: sources of risk
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What are the risks of diversification
While creating a diversified portfolio, care must be taken that
- cost of diversification does not become very high (funds other than domestic funds have high expenses)
- too many funds of the same type (more than 1-2 in the same category) reduces diversification
- diversification may reduce the return of the portfolio while reducing risk
These topics will be dealt with in future posts.
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