Understanding Diversification & its implementation

Diversification is a word that is often heard in the world of investment. Financial planners will tell you that you need to have a well diversified portfolio to reduce your risks, meaning that in case one asset does badly the impact can be cushioned by other assets doing well at the same time. We have all heard the adage – Do not put all your eggs in the same basket. Examples of diversification are available to us from all over – students try for multiple colleges and entrance exams in a variety of streams to ensure that they get admission somewhere. This is also an example of diversification.

In this post I wanted to outline the different kinds of diversification that you may want to consider for your investments. As always, I will try to relate it to my own experience in this aspect.

The most important kind of diversification is Asset Class Diversification.

  • Investments can be in Equity, Debt, Real Estate, Gold, Commodities, Currency etc.
  • Allocation will depend on the asset class and the time frame for which you want to hold it. Assets like Equity and RE are typically long term in nature. Currency and commodities will be for much shorter term.
  • I believe that for most investors, Equity and Debt investments allocated properly will be enough for all needs.
  • My personal investments are purely in Equity and Debt asset classes. I own an apartment but that was not acquired with an idea to invest. The small amounts of Gold and Currency I have are for consumption.

The next important type is Investment Vehicle Diversification within an asset class.

  • Within Equity you can choose your investment as Stocks or Equity MF.
  • Within Debt you can choose PF, PPF, FD, Debt MF etc
  • Make sure that your investment vehicles broadly complement each other.
  • I have investments in both Stocks and equity MF. I also have Debt investments in PPF and Debt MF.

The third important type is product diversification within the investment vehicle.

  • Within stocks you may want to invest in large caps, mid caps etc. Similarly you may want to invest in some specific industry sector such as Banking, Auto and Pharma etc.
  • Within MF you can invest in Large cap oriented MF, Mid cap oriented MF etc.
  • I’ll write about portfolio creation in future posts but my portfolio recommendation for MF has 4 types of Funds – Large cap, Multi cap, Mid cap and Small cap.

The fourth important type is geographic diversification based on location.

  • Main markets you can look at are US, Europe and Japan. There are funds available for each markets.
  • I invest in funds for US and Japan in a regular manner and for Europe in spurts.

Within the MF space itself you can further refine diversification in the following manner:-

1. Diversification among different Fund houses.
2. Within the same Fund house, diversification in different Fund managers.
3. Diversification in funds having different investment styles.

When you create a portfolio, diversification is an important consideration both for optimizing returns and mitigating risks. This is the reason why I am worried when people tell me that they need to invest in only one good MF or just in a particular sector of the economy like the large cap Banks. This may work well in the short term but is a fundamentally flawed idea, never mind who does it and how successful he has been.

In my future posts I will cover creating a portfolio of stocks and MF where diversification will be a key aspect.

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