With respect to your investments, diversification means having a selection of more than one type of security in your portfolio. For example, if your investment portfolio only has equity, it is a concentrated portfolio, but if it has a mix of fixed deposits, equities and some bonds, it is a diversified portfolio. Diversification is a risk management strategy since prices of different assets often move in opposite directions and having more than one asset in your portfolio helps limit the risk or impact of sharp price changes in one asset class. The logic is: don’t put all your eggs in one basket. Usually, you can diversify your investments in three ways.
Here, you invest across asset classes. So even if one type of asset performs poorly, there is a good possibility that other assets in the portfolio will cushion the loss. For instance, if you invest Rs 1 lakh in the stock market and the market undergoes a sharp correction, chances are you will make severe losses. But if you invest Rs 1 lakh in a combination of assets such as stocks, bonds and fixed deposits, the loss to the overall portfolio would be less. Vertical diversification is the first step to allocating funds or building a portfolio.
This refers to further diversification within an asset class. So, once your vertical diversification is done, within each asset class like equity or fixed income, you should ideally have more than one type of security. For instance, in equity funds, you could invest in a combination of large and mid-cap funds. Spreading your money across various equity funds is a form of horizontal diversification.
Similarly, if you own more than one type of debt-oriented mutual funds with varying duration (duration defines the risk level in a debt mutual fund), you are spreading the risk across the same asset class or diversifying horizontally.
When you diversify your portfolio by including assets from other countries, it’s called geographical diversification. The logic used is that different financial markets of the world are not highly correlated to one another or prices don’t always move in the same direction. Keep in mind that geographical diversification can happen vertically or horizontally.
Word of caution
Though diversification is a powerful tool, make sure you steer clear of over-diversification. For instance, having a variety of mutual funds in your portfolio is a good diversification strategy, but that doesn’t mean you have too many funds; pick up 7-10 funds from the Mint50 list to suit your risk profile and financial goals.
Also, remember that diversification is not a magic pill; market movement, good or bad, will impact your portfolio. Diversification cannot prevent your portfolio from making losses, but by using it, you can limit the losses in bad times.