Diversification In Investing: Why It Is Important?

Prakriti Nepal 

Investment tags along risk! Yup- So, it is necessary to lessen the risks involved in investing. This calls for diversification to lower the associated risks and increase the returns by managing risks. Diversification is one of the most important propositions of investing which helps investors to create a diverse portfolio. This way- the investor does not need to rely upon one single investment for all the desired returns. Thus, keeping a diversified portfolio is of utmost importance.


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What Is Keeping A Diverse Portfolio?

An investor primarily focuses on not holding one asset. For this reason, a group of investments in many different assets is created by the investor trying to mitigate the risk or lower the risks of investing, as much as possible. So the benefit of diversification ultimately becomes- decreasing the capital loss, to the portfolio of investment.

A common diversified portfolio constitute the below given mixture that would contribute in minimizing the investor’s risk profile:

  • Fixed Income
  • Commodities
  • Stocks
  • Insurance
  • Mutual Fund
  • Real Estate

Read: Where To Invest When Stock Market Is Over-Priced?  


The Importance Of Diversifying Portfolio

Investors diversify their investment across many different- big to small companies, various types of industries and classes of assets. This is done considering- whether you are investing inside your nation or doing foreign direct investment, investing  in stocks/shares or bonds, in real estate, mutual funds or whatnots. This will obviously spread the chances of risks and give a likelihood of lowering the risks to maximum possibilities. It is just like- not putting all of your eggs in a single container.

While making investment decisions- we can perform various sorts of analysis- from predictability analysis to SWOT analysis, to power analysis, to business intelligence analysis. Yet, despite all the analysis also, there is uncertainty regarding- whether the money put into various investment portfolios will give desired results and expected returns. The case can be even more sensitive if investment is focused only on one portfolio. Thus, it is important to diversify investment to save your capital as well as reduce the exposure to a big bang risk.

Market changes- every now and then, which makes the futuristic value of portfolios to fluctuate. Therefore, diversifying is not associated with only increasing the returns. There are high chances that someone who keeps all his money in one asset might outperform those investors who choose diversification also. Though, gradually and progressively a diversified portfolio does perform. Yet, diversification provides a sense of relief to investors because there are less chances of extreme loss situations when one owns a diversified portfolio.

With diversification, investors can also possess investments that execute in a different manner in alike markets. This can happen if the investment is done in different countries, different cities, or different time and situation. So, it is very necessary to identify where, how, why and how much to invest considering various factors such as:

  • Price
  • Product
  • Power
  • The company’s existential nature
  • The natural and favorable situations/conditions
  • Whether you are borrowing money for investing or utilizing your own savings
  • Whether you are buying a company or selling your company
  • If you are investing with knowledge in the stock/share market or just randomly attempting by listening to what others are saying.

Do you know that- when the prices of stocks increase, the price of yielded bonds usually comes down? So, awareness in terms of prioritizing investment decisions is also important while considering diversification of investing.


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What Are The Main Advantages Of Diversification?

Decreasing chances of loss : Loss doesn’t bring a desirable monetary situation. Hence, diminishing the loss circle is a favorable condition in investing.

Opportunities for return increases: With lots of small, medium to large investment decisions in various places- there will be more opportunities to gain preferable return.

Protects from unfavorable cycle of market: Market becomes unpredictable sometimes. Hence, keeping a plan B in investing always works.

Decreases the shakiness: – When diversification in terms of investing is done; it decreases the inconstant monetary situation and also reduces the chances of getting broke.


How Does The Diversification Of Investing Decisions Take Place?

Let us take some examples of stocks, bonds, commodities and cash.

Stocks: Stocks are usually preferred by investors when they want return on investment to be profit worthy and future worthy. Stocks are influenced by various factors such as political, economical, environmental, technological, even with mere statements by government position holders and changes in governance. Usually- stocks perform well when the economy does well. So, if various financial and technical analyses are performed in a smooth way, investment in terms of stocks can give profitable returns. Optimism plays a greater role in stock investing because the stock investors are ready to face downturn as they are optimistic about the future. Hence, stock investing is willingness based as well.

Did you know that- it is considered most convenient to diversify nearly 20 stocks opened out in numerous industries? Yet, having said that, if you possess stocks of a company, then you become a portion owner of that company too. This type of investing is usually risky because the growth of the stocks and shrinkage can both be very quick. As mutual funds are sort of containers of stocks- you can own mutual funds and can diversify the risks.

Those who want to retire early- it is recommended to acquire stocks because over a longer period of time, stocks’ performance is better than that compared to bonds. As per Benjamin Curry and Rob Berger- The Editors of forbes- in your portfolio of retirement- 70 percent to 100 percent of your assets’ are in stocks. Yet, when a person nears retirement- then there happens a shifting of portfolio to bonds- as it will decrease the elusiveness of portfolio, as the person who retires starts changing their investment to cheque.

Small cap versus large caps

Small caps= less resources,  higher potential of growth, higher returns atop lengthy periods of time, sentiment is bearish

Large caps= stable and mature investment, dividend stream is balanced, less of exceptional returns in enlarging markets.

Bonds: In case of bonds- bonds are somewhat opposite in nature than stocks. Bonds produce good returns when the economy is low or when the economy slows down. Since, Bonds are fixed income- the bond’s investors are okay in getting less returns to reduce the risks of investing. Hence, investors safeguard their bond holdings. Thus, bonds are basically IOUs which you can get from the Banks. You would be lending money to banks in contemplation of getting interest atop a fixed period of time. Henceforth, Bonds become safer because of the return rate which can be fixed.

Commodities: Commodities such as rice, gold, diamonds give return as per increase and decrease in the demand and supply. Situations such as lockdown, manipulation from sellers, less number of buyers, border sealing- all these are determinants. For Example, if there is more supply of Petrol and Diesel- then the diesel price falls.

Cash: Cash is fundamentally considered as liquid money. You put this money(cash) in savings and current account- for emergency use or for using it for any purpose whenever required.


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What Does Various Portfolio Diversification Theories Suggest?

As per modern portfolio theory; portfolio frontier is a group of portfolios which broadens the returns (expected) for standard deviation’s every level.

Let us try to understand with an example:

If an investor has 500,000 NPR which she invests in “A” Asset and 120,000 NPR which she invests in “B” Assets. She expects the return on A to be 10 percent and the expectation as return for “B” to be  3%. Here, portfolio return would be as follows:

Expected Return (ER)= [(500000/620000) * 10%] + [(120000/620000) * 3%] = [0.8 * 10%] + [0.19 * 3%] = 8.57%

As per corporatefinanceinstitute, “The expected return of a portfolio is the expected value of the probability distribution of the possible returns it can provide to investors.”

Another theory of diversification of investment is the model known as “ Swensen Model”, “Swensen Portfolio” or the endowment model developed by David Swensen and Dean Takahashi.

In this model, Swensen divides the portfolio into abruptly/roughly as much as 6 equivalent components and assets’ classes: (source: iwillteachyoutoberich.com) With this theory, we can see that investors’ choice doesn’t touch upon enormous portfolio components. Swensen is regarded as a legend of Investment.

Components of Portfolio       Weighting Percentage 
Equities (domestic) 30%
Funds of Real Estate 20%
Bonds of Government 15%
Developed- World International Equities 15%
Protected Securities- Treasury Bond 15%
Market Equities of emerging markets 5%
Total 100%

Though, if we simply would like to diversify our portfolio into different asset classes then diversifying the portfolio into various parts such as Stocks, Bonds, Commodity and Cash will definitely work.

Considering to diversify as per various industries is another useful way of diversifying investing.

Industry Wise Diversification Includes:

Location mapping: This is one of the prime factors because of Globalization.

Concurrently growing companies: Some companies can show that their decisions are working for them- despite any time, situation- such companies have profits and can gain good returns.

Entrepreneurship ventures: Some startups or even slow growing companies are more value driven- yet, their growth is quite slow and steady. Technical analysis needs to be done to find out these kinds of companies of various industries while analyzing for diversification of investing.


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Disadvantages Of Diversification

Having risk tolerance is key in diversification in investing. There can be certain cons associated with diversification in investing as well. Some of the disadvantages might be as follows:

Lack of understanding: For some investors, it might be a hassle to classify assets in their portfolio. Even if the CFA or CA does the classification- lack of investment knowledge can become a barrier to investors. So proper learning needs to be done.

Volatility nature: Due to the volatile nature of the market, there always exists continuous risk in terms of diversifying investing. After proper market knowledge only, diversification decisions need to be taken.

Over the top diversification: keeping no space for your daily running amount and simply diversifying also won’t make sense. Hence, average return= fees of transaction or high mutual fund fees(source: arbor investment planner), this needs to be well known to the investors.

Warren Buffet has usually been against diversification. He has time and again quoted as follows:

  • “Diversification is protection against ignorance. It makes very little sense to those who know what they are doing”
  • “ Wide diversification is only required when investors don’t understand what they are doing”

If we analyze both of the statements surficially, then probably- Warren Buffet here is mentioning not to- not diversify- instead, he is saying- concentrating only on the diversification part can be unpleasant sometimes. For people with mind, risk taking is their passion and it is instinctive. Hence- passion, instinct and knowledge mixed together can give good returns even if an investor invests a large amount in one stock as well. Gurufocus has mentioned that Warren Buffet has administered around 40% of his portfolio to one stock.

Conclusion

Hence, deciding what best suits you and what sort of investing shall give best returns- matters when it comes to diversification in investing. Sometimes planning works, sometimes pattern works and sometimes theories work. Nevertheless, gathering as much information as possible with regards to pros and cons in terms of diversifying investment always works. The basic flow of idea generation- analyzing the idea- situation analysis- industry and company analysis- profitability analysis- prediction and forecasting does work. Yet, being practical, doing calculations, monetary value analysis, expected return analysis and correlation analysis are eventually very necessary.

Therefore, decisions in terms of investment need to be done without idealizing any theories or experiences and keeping an open yet numerical state of mind. Reducing risk is the basis of diversifying and increasing/maximizing returns is the aim of diversification. Economic events need to be well studied and markets need to be well understood. Having confidence in the  holdings that you have should always be there and avoiding severe decline in any of the asset classes should be the target. Market Cycles and the connecting nodes of market cycles need to be conscientiously realized by the investor for performing worthy diversification in investing.


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