Diversification is a basic tenet of building and managing your investments. The idea is to include a variety of investments whose returns do not move in tandem in different market conditions so that a fall in the return from one type of assets is cushioned by a rise in another, thereby lowering the impact on the overall portfolio returns.
At the most basic level, just spreading your money into a large number of investments will see some risk-reduction benefits. But if diversification has to play the role of efficiently managing risks in the portfolio, then the selection of assets has to consider how the returns from each respond to risk factors and how these assets fit in with your financial goals and investment horizon.
Since it is such a comprehensive exercise, slippages and errors are bound to creep in that take away the efficacy of diversification. Here are some common mistakes that you need to watch out for.
You need to know what you have before you can decide whether or not you are efficiently diversified. List all your investment, irrespective of their value or how they are held, and then categorize them into equity, debt and other asset classes.
Often, people ignore the accumulated balance in the Employees’ Provident Fund or any stock options, and focus only on the investments made out of regular savings. But these typically constitute a large portion of your investment holdings and excluding them in estimating the asset allocation may lead to wrong decisions on risk and return from the portfolio.
A bloated portfolio is as undesirable as an undiversified portfolio. Holding too many investments in the portfolio will dilute the benefits of diversification. This is because after a certain point, adding new investments won’t reduce the risk, but may prove to be of poorer quality or fit and increase the risk in the portfolio.
Spreading the investments too thinly may also mean that you do not have enough exposure to well-performing investments. Higher costs associated with holding too many investments also drain the returns from the portfolio. The inability to keep track of the large number of investments may mean that you are holding on to investments that may be performing poorly or have become riskier than what you are comfortable with.
If you are well-versed with your investments, then you will do a better job of diversifying your portfolio. When you invest without understanding the features of an investment, you are likely to burn your fingers. People investing directly in equity or in real estate or buying insurance on the advice of friends and so-called experts are a case to point.
But there’s a flip side too: if you decide to invest only in products that you understand, you are likely to end up holding a highly concentrated portfolio. One way would be to pay for financial advisory services and have an adviser managing your investments.
Another way to work around lack of expertise or time would be to use investment vehicles like mutual funds. Evaluating individual investments to be included in the mutual fund scheme’s portfolio, monitoring performances and making sell, buy and hold decisions are the job of the fund management team to whom you pay a fee.
However, since it is your money at stake, you should take the trouble to understand the features of different investment assets available.
You may be putting your goals at risk if the asset allocation you have adopted to diversify your portfolio is not in line with them. For example, an individual close to retirement should have an asset allocation oriented towards generating income. But in an effort to be diversified if you still have equal portions of the portfolio invested in equity and gold, both of which are not oriented towards generating regular income, you may not be able to meet the income needs on retirement.
Similarly, consider an investment portfolio that has holdings in provident fund and other long-term equity and debt investment products, and add real estate to the mix. You will end up with a portfolio that is illiquid. You will either have to go the loan route or redeem investments at a loss or a penalty to fund the goal.
When you build a portfolio of diversified assets along with the risk and return features, you also need to align the liquidity features of the products to the needs of your financial goals.
Another common error is assuming that diversification is a one-time exercise. Your allocation to different asset classes will drift away from the original path over time as each investment will earn a different rate of return, which will skew the asset allocation. If you don’t periodically rebalance the portfolio, then the allocation will no longer be what is suitable to your needs and goals. Assess the allocation at a pre-fixed schedule and reallocate funds to regain the original allocation so that your portfolio continues to be balanced and is on track to meet goals.
Don’t ignore the diversification that is possible within an asset class. You can mix and match for better risk and returns from the portfolio, though it may be limited since sub-categories tend to move in the same direction. For example, within equity itself, look at different market capitalization segments and sectors in the market; within debt look at different credit profiles of issuers and tenors.
To ensure that your diversification exercise is successful and your portfolio bears returns in the best possible manner, ensure you avoid these five common mistakes.