Breaking a bigger problem (risk) into a minimal or manageable one – this is what diversification does to an investment portfolio.
Diversification, also known as asset allocation, is a strategy that helps you manage the unsystematic risks in investment. The idea behind diversification is to lower the risks, and help achieve higher yield returns on average. Thus, it cushions the negative impact of the adverse performance of any one (or a few) security in the overall portfolio.
Mutual Fund Diversification In Detail
The practical application of diversification to a novice may seem overwhelming and even intimidating, but the concept of this theory is quite simple. Let us elucidate it in three steps as given below.
i. An investor must first build a portfolio with the inclusion of various different investment instruments. This could range from options like stocks and bonds, to cash mutual funds and so on.
ii. The second step in diversification involves sorting the risk element of various investment schemes. You can do this by picking securities with a diverse risk levels. This way, if you face loss in one, the gains from the others can compensate for the that.
iii. Diversification can also be across different industries. It is important to take into consideration and pick securities according to industries in order to minimize the industry-specific risks.
What it means to diversify investment portfolio
There are certain investment instruments that tend to perform better than their counterparts. This depends factors like the prevailing interest rates, the market conditions and the performance of the currency market. It is however, important to note that diversification does not completely avert the risks. Rather, it can only minimize the impact of the loss on the investing portfolio.
Going for investment companies is one way to spread your investments across a broad range of assets. Exchange-traded funds also help reduce exposure to your portfolio of investments that form a certain index
Why is diversification important?
It is clear that diversification forms one of the most important principles in investing. If one seeks to grow their portfolio it is vital to diversify their investment.
- Diversification without any doubt protects the various asset classes in your investment kitty and helps it grow.
- As an investor, you get to explore more investment choices as you move from just one form to another. Nothing but dabbling and experimenting like this can educate investors and make them savvier in investing.
- Diversification allows investors to get familiar with different investment strategies. This way one gets to learn multiple approaches to investing from value-focused to growth-focused investing.
- The most important aspect of diversification is that it lowers the overall risk of investing in an investor’s portfolio.
- Many are biased towards the domestic market and tend to invest only within the confines of the country. Diversification makes an investor look beyond the national border, when seeking investment options. This opens a huge avenue for international investment.
- Investment in international market is as important as investing in the home country. This can minimize the portfolio risks during periods of economic recessions in the domestic economy and vice versa.
Thus, diversification helps investors achieve consistent returns on investments and ensures a smoother performance of the portfolio.