Portfolio management: Why it is important to diversify your invesments?
Portfolio diversification involves constructing a mix of different asset classes. Experts recommend consulting an advisor for portfolio management
PremiumPortfolio management enables you to effectively achieve your financial goals. The art of selecting the right investment tool which will be able to generate optimum returns is what makes up the portfolio investment. The best portfolio management will give you maximum return with minimum risk for the money invested in the given time frame. And for this investors need to diversify their funds across various types of asset classes
In an exclusive interview with Livemint, Shiv Gupta, Founder and CEO of Sanctum Wealth talks about portfolio diversification, its importance, and how can investors diversify their portfolios.
What is portfolio diversification?
Portfolio diversification is a fundamental investment concept based on the principle that various asset classes, geographies, industries, and financial instruments perform differently in different conditions.
It involves constructing a portfolio that includes a mix of different asset classes, such as cash, equity, debt, alternative investments, and commodities, and ensuring a minimum number of securities in each asset class. It is the equivalent of “not putting all your eggs in one basket" and extends to diversifying across geographies, industries, and investment styles.
Importance of portfolio management for investors
In simple terms, an investor’s two main tasks are to identify the asset allocation that best fits his or her objectives, profile, investment horizon, and circumstances, and to then ensure that they manage the inevitable ups and downs of markets and avoid making mistakes in times of market stress. The latter involves managing one’s own psychology. Portfolio diversification helps in both respects.
First, it forms the basis for asset allocation and allows investors to construct portfolios that are superior in terms of risk-adjusted returns. It also improves the potential for long-term returns through exposure to different asset classes, regions, and industries. For example, equities offer higher returns but higher risk, while debt instruments provide stability with lower returns, and holding both in a portfolio balances risk and reward, reducing overall volatility.
Second, diversification protects against market downturns as different assets respond differently under different conditions. For example, stocks may decline, but bonds or commodities may perform well. Exposure to a range of assets limits the impact of a downturn in any single asset class. This, in turn, reduces the stress an investor may feel during downturns and helps reduce the potential for making a mistake. Similarly, diversification within an asset class can reduce risks related to a specific investment. For example, a diversified portfolio of stocks and industries can help reduce the risk of an event impacting a specific stock/industry.
How can one go about diversifying one's portfolio?
Diversifying a portfolio involves several key steps.
The first is to identify your investment profile which is based on your return expectations, circumstances, and your psychographic profile, which defines your behavioral attributes in relation to investing. Then, determine the appropriate asset allocation that conforms to it. This is known as your strategic asset allocation, and it assigns a certain percentage allocation to Equities, Debt, Alternatives, and others. For example, a balanced portfolio investor seeking annual returns of 10-12% with moderate volatility would have a strategic assets allocation that could, broadly, look like 45% equities, 45% debt, and 10% alternatives (including gold).
Thereafter, when constructing the portfolio, diversify further by selecting a mix of investments across various sectors and geographic regions, and instruments that have a minimum number of securities in each class. For most investors, using collective investment vehicles such as Mutual Funds, PMSs, and AIFs would be advisable.
Then, regularly review and rebalance the portfolio to ensure it aligns with your desired asset allocation.
In all of this, it is always recommended to consult an advisor who can provide guidance in investment profiling, portfolio construction, and ongoing management.
If a person's annual income is ₹14 lakh. How much should he allocate in each asset, so that his portfolio is perfectly managed and diversified?
From an individual’s standpoint, the optimal portfolio is one that fits his or her investment profile and combines different asset classes in a manner that achieves the best possible risk-return combination, of which there are several for different levels of risk or return. In finance theory, this is an optimal portfolio. In identifying his or her optimal portfolio the concerned individual should consider both net worth and income and look at this alongside their investment profile.
Let’s take an example. For a young professional with a reasonably high-risk tolerance, a 20 lakh corpus, and a 14 lakh income, of which he saves 20%, an ideal portfolio could look like this:
Equity mutual funds – 70%
Debt mutual funds – 20%
REITs, INVITs – 10%
To execute such a portfolio the individual should use mutual funds and ETFs and consider deploying a systematic investment plan.
By spreading investments across different instruments, investors can potentially minimize the impact of any single investment's poor performance on the overall portfolio at any point in time. Also, while it is seen mainly as a risk reduction tool, it can improve returns adjusted for risk
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