Diversification is a technique which minimises the risk of investing by spreading investments across various financial instruments, asset classes, sectors and other categories.
The aim is to minimise the chance of loss in the overall portfolio since different instruments react differently to market conditions. For example, the rising cost of petrol and diesel is good news for oil marketing companies, but bad news for consumers, since it leads to higher inflation and makes goods and services costlier. A diversified portfolio helps in balancing the overall returns by compensating for the losses in one asset class and/or sector with gains in another. Here are a few types of diversification.
- This type of diversification aims to spread investments across different asset classes.
- Different asset classes react differently to the same market or economic condition. Diversification across asset classes can help you enjoy the best of both worlds in times of high and low volatility.
- As an asset class, a slowing economy is bad news for equity, as investors look to safer havens like fixed-income instruments and gold. Similarly, news of healthy economic growth bodes well for equity, as investors are willing to take higher risks for higher returns.
- There are several asset classes, such as equity, fixed-income instruments, gold, real estate and cash that can help you diversify your investments.
- It is useful to diversify among different asset classes, but it also pays to be diversified within one asset class.
- For instance, within equities, you can diversify between different types of funds, such as large-caps, mid-caps and index funds. Direct stock investors can invest in different sectors, say, automobile, banking and oil marketing companies.
- Diversification also works organisation-wise. For instance, it may not make sense to buy all your mutual funds from a single fund house. In case one asset management company goes through a tough period, you will have investments in others to balance it out. The closure of six schemes by Franklin Templeton in April 2020 is a case in point.
- This type of diversification aims to reduce geopolitical and country-specific risks. For instance, several countries placed restrictions on Russian companies after Russia invaded Ukraine early this February.
- Investors can now put in money in various foreign markets, too, such as the US, Hong Kong, Taiwan, Japan, Brazil, China and others, through global mutual funds and stocks, among others.
- This may require you to put in some extra research. For example, lowering of steel import duty by Europe is a positive development for Indian steel makers, but negative for European steel makers. You need to have knowledge about local market conditions abroad to make proper investment decisions.