Diversification is both an art and science of spreading one’s capital by investing in varying asset classes, & sectors in order to reduce the risk, emotional stress and volatility over time in the market. Investing solely in risk-free instruments offers lower expected returns and cannot beat inflation in the long run, whereas investing solely in equities leaves the portfolio open to high market volatility. Diversification is thus a risk management technique that provides an investor with higher average long term returns with relatively lower risk over a period of time.
*The above examples are not exhaustive.
The aim of a diversified portfolio is to reach the targeted optimum level of risk & return. As each asset reacts differently to a particular market event, a well diversified portfolio tries to maximize returns by diversifying a portfolio into different asset class like equity, gold etc & then further diversifying in a particular asset class like in equity further diversifying into different sectors like Automobile, FMCG etc
In 2008 -09, equities crashed approx 39% due to the global financial crisis; however, at the same time gold registered a stellar performance of approx 24%. The next year, equities surged approx 94% while other asset classes noted subpar returns. As human behavior generally leads to risk averseness during market downturns, most investors would have exited the equity markets in 2008 – 09; missing out on the rally next year.
Therefore, for an investor who had only invested in equities in 2008-09, the portfolio value would have dropped by a humongous amount, causing irreparable stress and anxiety. In the same manner, for an investor who had only invested in gold in 2009 – 10, the returns earned would be insignificant as compared to that of equities.
A diversified portfolio, thus, aids in bringing balance between risk and reward and generates steady returns during both the market extremities.
Source: Economic Times. Figures are returns from the asset classes during the financial year.
While diversification does not guarantee protection against systematic risk, it goes a long way in ensuring one achieves financial goals with ease. Investing aggressively or conservatively has its own perils. A diversified portfolio becomes the stepping stone towards reaching financial goals steadily and successfully.