Have you ever considered whether you have properly allocated risk to your current investments? Are you sure your investment portfolio is ready to give you returns and avoid losses in negative circumstances? These are just a few questions you should ask when planning for investment. It is a crucial decision, and planning it precisely is important. You must have a proper mix of investment options to gain the most. This calls for the adoption of a proper diversification strategy to ensure benefits in the long term.
But what are the diversification strategies? Well, let us learn about the diversification strategies in the guide here. Also, let us find the answer to the question, “Is it a good business strategy to diversify?”
What Is Diversification, And Why Should You Diversify?
Diversification refers to spreading or distribution in the literal sense. When considering portfolio diversification, it is the distribution of your investments among multiple options to reduce the risk while ensuring better returns. As said, you should never put all your eggs in one basket; the same is the idea behind the diversification strategy.
To understand this better, here is a simple diversification strategy example.
Suppose you invested INR 50 in Stock A and INR 50 in Stock B. At the end of the year, Stock A fell by 50% while Stock B gained by 75%. Now the values are INR 25 and INR 87.5. The total return is INR 112.5.
This is the benefit of adopting the diversification strategy. From understanding the market and stock trading to planning your investment, diversification allows you to get a good return for your investment. Even though there are multiple diversification strategy examples, it is important to understand the top reasons to diversify:
- To maximize the potential return.
- To reduce the risk.
- To have a better and more stable portfolio.
- To have more flexibility.
- To gain the shield against volatility.
No doubt, you can gain multiple benefits by diversifying your portfolio. But do you know all the types of diversification strategies? A diversification strategy involves quite a broad spectrum of plans and knowing them can help you gain better returns per your goal and risk appetite. So, let us understand this first here.
How Can You Diversify?
Diversification is the first piece of advice that every financial advisor will give you while creating your portfolio. The basic idea behind this is to be money smart, ensuring you gain the best and highest returns. Consider this as spreading the weight over a larger base to avoid falling off.
So, here are a few things that you should consider while diversifying your portfolio:
1] Define your investment goal
Start with defining your goal. This can be a short-term or long-term goal. Understanding the goal will help you better analyze the funds that you can invest in. A long-term goal can go with equity-based and closed-ended funds, while if you have a short-term goal, you can always use open-ended or debt-based funds.
2] Create your budget
The investment should always be based on your budget. When you plan to diversify, you should know the surplus in your hand and have liquidity. Several diversification strategy examples focus on the same concept to help you have a smooth financial run.
3] Know all your options
There are multiple investment options available in the market. Each of these has pros and cons of its own. The most important factor in understanding here is to compare the options based on your return needs and risk appetite. Even if you invest in one variety of funds, a thorough analysis of all the variants is essential for a good return.
4] Define your investment timeline
When you are diversifying your portfolio, ensure to define the timeline. From the entire surplus, you might have a portion that you can invest for the long term and a part that you can invest for the short term. This can be planned by considering your upcoming financial needs.
5] Identify the cost involved
One of the most important aspects to consider when diversifying is the cost involved. The cost of investing in equity differs from the cost of investing in debt. Considering the cost will ensure you do not have hefty fees to pay for your investment, which might reduce your return value.
Once you know the reasons for diversity and the right way to diversify, you should know the various diversification strategies for better planning. So, let us find out more about them.
Different Types Of Diversification Strategies
Diversification is simple but incomplete if you are unaware of how you can diversify. Knowing your goals, options, budget, timeline, and cost are of prime importance when you are moving ahead for diversification; it is equally important to understand the strategy you can adopt. It is based on the investing psychology of an individual.
Some investors might wish to go aggressive, while others prefer to play safe. There are chances a few investors might prefer only one asset or area while others have multiple choices and time frame needs. Based on this idea, strategies are devised. So, let’s explore the types of diversification strategies with examples here:
1] Across and within an asset class
The basic idea behind this diversification strategy is to invest in multiple options simultaneously. This diversification strategy example is investing in stocks, debt funds, mutual funds, real estate, bonds, fixed deposits, commodities like gold, and cash all at a time. Based on your risk appetite, the diversification is planned out.
It is when you invest only in one kind of asset but diversify your funds within the same asset. You can understand the diversification strategy example by investing in the stock market. Suppose you only invest in the stock market; then, you can invest in multiple stocks. This is also called position strategy.
You can also have a diversification strategy based on geography. The idea is to invest a part of the funds based on the location. You can invest a part in the developed markets and another percentage in emerging markets. Another thing you can do is invest in real estate across different countries.
3] Company size
Small-cap, mid-cap, and large-cap companies are running in the market based on their market capitalization. You can invest in these companies and diversify your funds among the same. This kind of diversification strategy is quite helpful in reducing the risk and ensuring a greater return.
4] Time based
You can also make investments over a longer period, such as those with a medium-term, short-term, and long-term time horizon. Planning investment for different ranges of timelines including 6 months, 2 years, or 5 years is quite a helpful strategy. It will offer you funds in the long run without hampering your liquidity.
5] Investment style
For risk diversification, you can select from a variety of investment styles. Investment diversification strategies come in three flavors: growth, value, and index. The growth strategy allows you to invest in fast-growing funds. While the growth plan is simple, the value strategy involves extensive research to identify inexpensive stocks. In contrast, index investing is quite simple because you don’t have to choose the companies. Simply decide on the benchmark index.
Advantages Of Diversification
Now, when you have the types of diversification strategies with examples, it’s important to analyze the pros and cons. So, here are the top advantages of the diversification strategy:
1] Risk mitigation
The most important benefit of the diversification strategy is risk mitigation. Diversifying the funds in various options reduces the risk and offers you a balanced return. Also, when a few options turn non-performing, diversification will safeguard you from the loss by absorbing shock.
2] Better returns
Diversifying your portfolio gives you a better chance of earning higher returns. A diversified portfolio will take less risk than a concentrated one, even when two portfolios produce the same returns. The second one will be more volatile than the first.
3] Safeguard against market shifts
When the market enters a new phase of the market cycle, diversification can help safeguard a portfolio. The cycle involves a growth period, stagnant, and a crash. You can also call this a bullish or bearish market. A diversification strategy ensures that during the growth, you earn great, but at the same time, you do not suffer a high loss during a crash. But a non-diversified portfolio will potentially fail during the crash.
4] Reduced volatility
By holding a mix of assets, you can also lower the volatility in your portfolio. With diversification, you can ensure that you earn a great return on funds, even when you face volatility in one sector or asset class. A proper diversification strategy makes your portfolio less volatile by offsetting the position of one fund against the other.
5] Leverage better growth
You may take advantage of the growth opportunity each industry offers when you invest in various assets in each area. Markets frequently have cycles when one sector outperforms the others, and you can only benefit from these cycles if you have exposure to that sector.
6] Stability and peace of mind
This is indeed one of the biggest benefits of a diversification strategy. It provides your portfolio with the security and assurance it needs to better withstand a downturn. It eliminates the emotional element from investments necessary for reaching the desired aim and provides a more predictable return.
Disadvantages Of Diversification
Unlike any other thing, there are downsides to diversification strategy planning. The cons are as follows:
A diversification strategy is not that simple to chart down. You need to focus on multiple aspects before you plan your investment. If you fail to diversify as per your requirement, you might lose or have insufficient funds.
2] Can limit growth
While diversification of a portfolio safeguards you from falling, it also limits the chances of growth. You might limit your returns if you create a portfolio with options that offer you an average return. Hence inefficient planning can reduce your profitability too.
3] Can be risky
A diversification strategy can be risky if you entirely invest in high-yielding and high-risk options without focusing on the volatility and market cycle. Though this will give you a return during a period, there are chances you might fail to face losses during the crash or negative market cycle.
Every investment has different taxation policies. When you have a diversified portfolio, you are required to know the taxation needs of the same. Failing to meet the taxation needs of different asset classes might cause loss or penalty.
5] High cost
Every investment option has a different cost associated with it. When you create your diversification strategy, you must also focus on the cost. If you invest all your funds in high-cost options, you will dilute the returns you can make.
6] No guarantee
Many investors think that the diversification strategy is a guarantee of earning great returns. But this is not correct. Even when you diversify, you must make regular checks and keep an eye on your investment to ensure growth. Failing to do so can lead to negative returns as well.
Knowing and selecting a diversification strategy is not enough. You should know the pros and cons and tips that can help you plan the investment correctly. So, here are a few tips that you should know:
- Strike an efficient balance between equity and debt.
- Maintain consistency in your investment.
- Always select investment options with varied time frames and returns.
- Plan out your exit strategy as well. You should know when you are required to redefine your portfolio to ensure you avoid losses.
- Avoid being so heavily diversified that you fail to meet your immediate or unforeseen needs.
- Invest only a fraction in locked or illiquid options. This will allow you to use your funds when needed.
- Mixing emotions with investment is never a good idea.
- Ensure to rebalance the portfolio based on the market cycle.
- Move out of an investment in case of persistent negative results. This can hamper the overall investment.
Diversification is not simple and requires time to plan thoroughly. Just like you need time to research your first job in finance, similarly, you are required to invest your time in planning the diversification strategy. Investing in various assets can mitigate market volatility and ultimately achieve a steadier rise over time. Whether you create a conservative or balanced portfolio, ensuring that you have the proper diversification and liquidity will make sure that you meet your current and future financial needs with ease.
Always remember that diversification strategy reduces risk and not eliminates one. Find a risk-return balance that works for you so you can generate decent returns without continuously worrying about your portfolio.