When you start your investment journey, one of the first things people advise you to do is to diversify your portfolio. This is an oft repeated advice which has helped investors tide over uncertain times and smoothen their portfolio returns. Diversification simply entails spreading our investments across multiple instruments that are differentiated in their risk/return profile. It stops you from pinning all your hopes and fortunes on a single stock or instrument. In the current investment climate, where we are witnessing heightened volatility and an alarming rate of credit events, building a diversified portfolio becomes even more relevant.
Your risk profile determines your risk-taking capacity after assessing your ability, willingness and need to take risk. Basis the risk profile, investors can broadly be categorised into three risk categories: 1. Defensive 2. Balanced 3. Aggressive. You can further classify risk profile into moderately defensive, growth, high growth etc. An indicative allocation for each risk profile might look something like the allocations below.
- 70% to 90% in Defensive assets
- 10% to 30% in Growth assets
- 50% Defensive assets
- 50% Growth assets
- 10% to 30% in Defensive assets
- 70% to 90% in Growth assets
Defensive assets consist of bonds, bank deposits and certain fixed income instruments whereas growth assets include stocks, property and other alternative investments. Diversification in asset class can help investors during a major economic change like interest rate hike and other macroeconomic developments.
Once you have determined your risk profile and asset allocation, you should diversify your funds within assets. While investing in equity, you should consider investing across different sectors (consumer durables, non-durables, industrial, agricultural) and market capitalisations (large caps, mid-caps or small caps).
Similarly, you must also diversify among defensive assets. There are some instruments that carry minimal levels of risk like bank fixed deposits and funds investing in government securities. On the other hand, there are other fixed income products, like credit risk funds, that carry higher levels of risk but also generate higher yields.
Looking at the current geopolitical landscape and the consequent impact on world trade, growth and currencies, one should also consider investing a part of their portfolio in overseas instruments. These investments can provide a hedge against a rupee depreciation and take advantage of investment opportunities that might not be available domestically. Investors can invest in overseas securities through international funds.
There is another saying that goes, “too much of a good thing is a bad thing”. Diversifying your portfolio across too many assets and instruments can dilute your portfolio returns without giving it the necessary risk protection. So, it is important to optimize your portfolio and diversify judiciously in order to get the best risk-return mix.