“Diversification is protection against ignorance. It makes little sense if you know what you are doing.” – Warren Buffet
Portfolio diversification works on the never put all your eggs in one basket premise. Simply put, it is an investment strategy that caters to a large array of risk appetites and hedges them by spreading the investments across different asset classes, instruments, industries, and regions. It creates the effect of stabilizing one’s portfolio of investments by hedging high-risk bets against more stable assets, liquid or cash equivalent reserves such as bonds against long-term high-return investments such as real estate.
The global economic turmoil of the last few years has necessitated a hard look at individual portfolios and calls for the broadening of capital assets and smart risk management. The volatility in the markets across regions, industries, and asset classes has been influenced by dynamic geo-political situations, supply chain disruption, inflation and interest rate hikes, and emerging government policies.
For example, the Inflation Reduction Act of 2022 by the US government has hyper-accelerated investments in green technology creating long-term investment opportunities in industries as diverse as semiconductors, mining, EVs, solar panels, and technology. This has also had a comparable effect on the long-term growth outlook of fossil fuel companies and sectors. Portfolio management in such cases needs to consider the individual strategy, size, risk appetites, and other personal considerations.
The underlying idea, thus, for a great diversifying strategy needs to consider the various moving parts and creatively stabilize the overall portfolio performance. Diversification provides a layer of protection against concentrated risk, helping to produce more consistent returns over time. It does not guarantee higher returns or protect against losses. It can help mitigate some, but not all, risks.
Here, we are looking at six tips from investment gurus on how to effectively diversify your investment portfolio.
Diversify across Asset Classes
This is a no-brainer. There are different kinds of asset classes. Ensure that your portfolio has a healthy mix of equities like mutual funds, ETFs, and stocks, fixed-income investments such as bonds and deposits, liquid investments in cash deposits or cash equivalent investments such as treasury bills and commercial bills, and hard assets like real estate, gold, and other commodities.
Across these different classes, there are diverse risk and return exposures. Spreading your investments across these asset classes will help balance your portfolio and hedge your risk against long-term economic shocks. In general, an investment portfolio needs to have at least two asset classes to be considered diversified.
Further Diversity within the Asset Classes
It is not enough to have investments across different asset classes. Within these assets, there should ideally be further diversification across industries, regions, individual companies, fund types, and risk profiles. This is likely to ensure greater cushion, middle-term security from regional shocks, and increase risk appetite.
The ups and downs of geopolitics call for a greater spread of wealth across geographies. Worldwide investments can help balance regulatory shocks, downturns, political upheaval, and regional uncertainties. Similarly, investing in companies of varying sizes offers varying returns and risks. Larger companies tend to be more stable with lower risk profiles, while smaller growth-stage companies carry larger risk but potentially huge returns. Smart investing considers such diverse factors when building a long-term portfolio.
Safe is a Good Baseline Strategy
Certain investments are less risky than others. Target date funds such as retirement funds, life insurance, and trust funds, are safer, with lower returns, and need much less involvement. These are the building blocks of a healthy portfolio. A strong foundation with long-term investment security is key to taking bigger risks.
Another way to build a diversified portfolio at a low cost is index funds . It reduces management fees, is more hands-off, and is a great way to start building up your portfolio. You can engage more actively in these index funds and try and get further exposure to specific industries or sectors that you might be personally interested in and are underweight.
Healthy Liquidity is a Must
You never know when life throws emergencies at you. If you need a little cash infusion suddenly, it is important to have cash or cash equivalents at hand. Cash at hand is often undervalued, especially considering its inflationary effects, but it protects in emergency scenarios, market selloffs, or systemic shocks. It can also provide leverage in times of market downturn.
Cash or easily liquefied investments such as government bonds, treasury bills, bank deposit certificates, corporate commercial paper, and other money market instruments, can be used in highly opportune moments of investment bargains. Cash equivalents are a form of future hedging with a contingency fund for personal use or further investments. Some kinds of mortgages can also be considered under this category.
Consider Alternative Investments
In India, there is a deep tradition of investing in commodities such as gold and silver, real estate and land, and other forms of alternate investment instruments. From our grandmother’s gold horde to the land that many of us have in our villages, these have been historically seen as the most secure investments carried on from generation to generation.
Today, the definition of alternate investments is quite broad and includes categories such as cryptocurrencies, REITs , emerging commodities such as rare earth metals, art and collectables. These investments are not all vetted and some, like crypto, have seen high volatility in recent times. But these are often high-return, long-term investments and are highly recommended in a high-performing diversified portfolio.
Rebalance Regularly
Finally, every portfolio needs periodic rebalancing. It is inevitable that over time, certain investments increase in value, while others don’t. Rebalancing is a continuous negotiation between the risks taken and the returns gained. This exercise can help your portfolio stay updated, healthy, and balanced across different market conditions.
This exercise may also be contingent on major events such as personal emergencies, market crashes or runs, and sudden policy shifts. Rebalancing offers you a chance to reapportion the weights in your portfolio, ensuring that your portfolio is in line with your overall strategy and risk appetite.
Learn Investment Management and Portfolio Diversification
The ATLAS Edge Executive Program in Investment Management is an intensive one-week program meant for the serious investor. It will feature some of India’s leading investment gurus who will take different modules on the different types of asset classes, investment strategies, economic conditions, and alternate investments. The program includes tips and tricks on decoding market trends, reading financial statements, and diversifying portfolios.
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