Portfolio diversification is a risk management technique that involves the process of investing your money in different asset classes and securities in order to minimize the overall risk of the portfolio. Diversification lowers the risk of your portfolio. Doing this often reduces the volatility (up-and-down performance) of your portfolio. A very basic diversified portfolio might contain the following investments:
- Stocks and mutual funds (most risky, but with the highest potential growth)
- Bonds, including treasury and corporate bonds (less risky, but with lower potential growth)
- Certificates of deposit (CDs) and money market funds (least risky, with very small growth)
Even if a part of your portfolio is declining, hopefully the rest of your portfolio would be growing. Thus, few of the impacts of a poorly performing asset class on your overall portfolio can be potentially offset.
Types of Portfolio Diversification
- Based on asset class:
Portfolio diversification in this implies allocating your funds into more than one asset class such as stocks, mutual funds, real estate, debt market, commodities etc. This kind of diversification allows you to balance your portfolio and fight from the risk of failure of a particular asset class. Another way to invests your money in one asset class but in different kind of instrument or company, and diversify portfolio in this manner.
- Based on Geography:
Geographic location also plays a crucial role in portfolio diversification. You may invest into securities of one or many countries subject to the rules framed therein and earn the benefit of currency fluctuations. You may also purchase property abroad. Good knowledge about the foreign market is required before Investing in stocks of other countries.
- Based on Time:
Diversification is also substantiated by the maturity period of the investment pooled in the portfolio. For example: you have taken a 10 year old fixed deposit, in that case liquidity factor is most affected because your funds are blocked for that maturity period. On other hand investing in fixed deposit of different maturity period say, 2, 3, 5 or 10 years will give you diversification and you will not be hit by the liquidity factor.
- Based on Investing style:
Depending upon the style of investing, an investor always has an option to invest in a diversified portfolio. You can either invest in products which are giving you a fixed income, or the products which are just for growth purpose. Keeping a mixture of both gives a larger room for diversification, as speculation as well as growth both gives you a balanced portfolio mitigating the risk of damage to the portfolio as a whole.
Factors affecting Investment Decisions in Portfolio Management
- Risk Tolerance – Risk refers to the volatility of portfolio’s value. An extremely important factor is the amount of risk which the investor is willing to take on.
- Return Needs – This refers to whether the investor needs to emphasize growth or income. Younger investors will want returns that tend to emphasize growth and higher total returns. Retirees depends on their annual income will want consistent annual payouts.
- Goals – Exactly what is it that you are trying to accomplish? Is your objective is to accumulate or to hold on the wealth you already have?
- Time Horizon – The length of time you will be investing is important because it can directly affect your ability to reduce risk.
- Tax Exposure – Investors in higher tax brackets prefer such investments where the return is tax exempt, others will have no such preference.
- Risk Reduction
Risk cannot be eliminated completely, but you can manage your level of risk. Some amount of risk is involved in every investment. Portfolio diversification tends to reduce your long-term risk. Diversifying into safer fixed income assets may have helped to reduce risk and maximize returns. Most diversified portfolios do not achieve complete elimination of loss but only reductions in its potential.
- Capital Preservation
Some investors strive for capital appreciation, while some use capital preservation as an investment strategy. Rather than focusing on the rate of return for your investments, capital preservation allows you to protect the capital you have. Diversification makes it much easier for an investor to protect their capital, by allocating money to different investments.
- Higher returns
Portfolio Diversification can enable a portfolio to grow both when markets boom and returns falls. Their portfolios would experience greater returns, if these investors had diversified their portfolios to include investing in metals, commodities, and bonds. Diversification gives an investor the chance to achieve positive returns in one market when other market is generating negative returns.
Behavioral portfolio theory states that investments either protect you from loss or provide high-growth potential. A diversified portfolio has a higher percentage of income, lower risk and high value investments. More than one financial goal could be achieved through Portfolio diversification.