What is diversification: how and why should you do it?
Diversification is spreading risk across various investments so that all of them don’t perform equally bad (or good) at the same time
Diversification is spreading risk across various investments so that all of them don’t perform equally bad (or good) at the same time
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:
Each type of investment (e.g. a company) has two sources of risk:
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?.
Join the Arthgyaan WhatsApp community: You can stay updated on our latest content and learn about our webinars. Our community is fully private so that no one, other than the admin, can see your name or number. Also, we will not spam you.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
We will deal with the various allocations and returns in future posts.
Related reading:
While creating a diversified portfolio, care must be taken that
These topics will be dealt with in future posts.
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This post titled What is diversification: how and why should you do it? first appeared on 28 Jun 2021 at https://arthgyaan.com