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Diversified portfolios play a crucial role in investment strategies, offering essential benefits and requiring specific approaches for effective implementation. By spreading investments across various asset classes, investors can mitigate risks and optimise returns. Understanding the significance of diversification and employing appropriate strategies are key components of building a resilient and successful investment portfolio.
Table of Contents
Defining Portfolio Diversification
A diversified portfolio is a collection of different investments that combine to reduce an investor’s overall risk profile. Diversification includes owning stocks from several different industries, countries (yes, that’s possible with Share India), and risk profiles, as well as other instrument types such as bonds, commodities, and real estate.
These various assets work together to reduce an investor’s risk of a loss of capital (and profits) and their portfolio’s overall volatility. In exchange, the returns from a diversified portfolio tend to be lower than what an investor might earn if they were able to pick a single winning stock – technically speaking (although no successful investor ever bets on a single stock alone, the risk is simply too high).
Components of a Diversified Portfolio
A diversified portfolio should have a broad mix of investments.
- For years, many financial advisors recommended building a 60/40 portfolio, allocating 60% of capital to stocks and 40% to fixed-income investments such as bonds.
- Meanwhile, others have argued for more stock exposure, especially for younger investors.
- While traditional portfolio allocation models like the 60/40 strategy have been popular for decades, it’s crucial for investors to learn about modern approaches to portfolio diversification, including strategies like stock lending and borrowing (SLB).
One of the keys to a diversified portfolio is owning a wide variety of different stocks. That means holding a mix of tech stocks, energy stocks, and healthcare stocks, as well as some from other industries. An investor doesn’t need exposure to every sector but should focus on holding a wide variety of high-quality companies. Further, investors should consider large-cap stocks, small-cap stocks, dividend stocks, growth stocks, and value stocks.
In addition to owning a diversified stock portfolio, investors should also consider holding some non-correlated investments (e.g., those whose prices don’t ebb and flow with the daily gyrations of stock market indexes). Non-stock diversification options include bonds, bank CDs, gold, and real estate.
Tips for Building a Diversified Portfolio
Building a diversified portfolio can seem like a daunting task since there are so many investment options. Here are three useful tips to make it easy for beginners to diversify.
Stock Diversification
- Spread Investments: Aim to hold stocks from 10 to 15 different companies across various industries to mitigate risk and ensure a balanced portfolio.
- Consider Index Funds: Index funds offer hassle-free diversification across multiple industries with low expense ratios, making them a convenient option for those with limited time for individual stock research.
Fixed-Income Allocation
- Balance Risk: Allocate a portion of the portfolio to fixed-income assets like bonds to reduce overall volatility and enhance stability.
- Explore Bond ETFs: Bond-focused exchange-traded funds (ETFs) provide exposure to fixed-income assets without the complexities of individual bond selection, offering diversification within the bond market.
Real Estate Investment
- Enhance Diversification: Consider adding real estate to the portfolio to improve overall returns and reduce volatility.
- Explore REITs: Real estate investment trusts (REITs) offer exposure to the real estate market without direct property ownership, providing diversification and income generation. Allocating 5% to 15% of the portfolio to REITs can further enhance diversification.
Conclusion
Diversification acts as a protective measure against putting all eggs in one basket. While it may limit potential returns, it significantly reduces exposure to individual stocks or industries, thus minimising volatility and the likelihood of unfavourable outcomes. Armed with this understanding, investors can make informed decisions to achieve a balance between returns and risk. One can consider leveraging industry-leading tech platforms like Share India for the investment journey.