How not to invest money: The diversification dilemma

All investments carry some degree of risk. Therefore, one of the challenges for investors is to manage risk in their portfolios. If you are an existing investor or looking to start your investment process, you must know that diversification plays a key role in managing the risk in your portfolio. In fact, it also helps you tackle different market conditions.

However, to benefit from the true potential of diversification, it is important that you diversify your portfolio both in terms of allocation to different asset classes, as well as within an asset class. While a goal-based investment approach goes a long way in ascertaining the right mix of asset classes in your portfolio, an investment option like mutual fund allows you to diversify efficiently within an asset class.

For example, for the equity portion of your portfolio, you can choose from a variety of funds like those investing in different segments of the market, that is, large cap, mid-cap and small cap, multi-cap funds, index funds, sector and thematic funds as well as specialty funds. Unfortunately, diversification is also an aspect of portfolio building where investors usually err. Many investors invest haphazardly in mutual funds and, hence, end up having a large number of funds in their portfolios. Besides, there are those who think that investing in a number of funds will help them diversify their portfolio. If you are one of those investors who have built an over- diversified portfolio, you must know that too many over-lapping funds would invariably make your portfolio quite unwieldy and that can be harmful for your portfolio in the long run.

In fact, over-diversification can harm your portfolio in more than one way. For example, investing in too many mid-cap/small-cap funds for the sake of higher level of diversification would invariably make you compromise on the quality of the portfolio, as stock picking and sound investment process are major differentiators for these funds.

Considering that these two segments suffer from poor liquidity and limited coverage, it is always prudent to opt for funds that not only have quality portfolios, but also have an established performance track record. Remember, a few carefully selected funds in your portfolio could provide you much higher level of diversification and without compromising returns.

While there is nothing like an optimal number of funds that you need to own to have a sufficiently diverse portfolio, factors like size of the portfolio and your asset allocation to different asset classes can help you decide that number. You must also consider the level of risk you are willing to take to meet your returns expectations. Risk tolerance should also be addressed from two perspectives: financial risk tolerance and emotional risk tolerance.

Another important aspect of diversification is time diversification, that is, remaining invested over different market cycles. It is particularly important when you invest in a volatile asset class like equity. Considering that volatility is a natural phenomenon in the stock market, a disciplined investment approach coupled with long-term investing can help you stay the course. In fact, longer time horizons allow you to take on greater risks, with a greater potential to earn better returns, as some of these risks can be reduced by investing across different market environments. Similarly, if your time horizon is short, you would have greater liquidity need. Hence, the focus should be on investment options that provide liquidity with reasonable degree of safety of capital.

A diversified portfolio across different asset classes brings about the right balance between risk and reward. Investing aggressively and /or conservatively has its own perils and, hence, asset allocation and rebalancing it once a year can allow you to climb the ladder of investment success consistently.

Hemant Rustagi

(The writer is CEO, Wiseinvest Advisors)

Source: DNA Money