Diversifying your stocks in the share market means to spread your investments to reduce your exposure to merely one type of asset. This system is considered useful in cutting down the volatility of an investor’s portfolio over a period. However, it can help to know that diversification is not a guarantee against loss, nor does it promise assured returns.
To understand what diversification means, here is an instance -- a beach shack store sells seemingly unrelated items, such as sunglasses, swimwear, umbrellas and footwear. Although it may appear odd on why the seller would sell umbrellas and sunglasses at the same time, there is an excellent reason for it. When it is raining, it is easier to sell umbrellas and sunglasses, and while it is sunny the reverse becomes true. By anticipating rainy and sunny weather, the seller is selling different products to cut down his risk of not going without a sale every day.
This can give you a good start on understanding diversification.
The wonder of diversification
In the stock market, you can pick a group of investments or asset classes based on your financial objectives. These investment groups, also known as asset allocation, can help in limiting your losses and the changes in your investment gains without having to offer up a good deal of potential yields.
In diversification, asset allocation is crucial because it plays a significant impact on how you meet your financial objectives. If you do not have enough risk in your portfolio, you may not be able to achieve your goals. For instance, if you aim to save towards retirement or future college education, you may want to include some stock in your portfolio. At the same time, if your portfolio holds too much risk, you may not have the requisite funds when you need it. Say, if your portfolio is based heavily in stocks, short-term goals such as saving for a family summer vacation may not get accomplished.
Let's understand diversification in the Indian stock market with the help of an example.
Nayan has invested Rs. 140,000 in his portfolio. His portfolio consists of 10 stocks that are trading in various sectors, currencies and geographical locations. To prevent risk, Nayan has invested in Company A, Company B, Company C and Company D.
The total value of his portfolio is Rs. 140,000 and the current value of his portfolio is Rs. 143,225.
Here, Nayan has realised a profit of Rs. 3245 or a portfolio return of 2.32%. While some of the stocks in his portfolio have not performed well, others have given him high returns.
To calculate his exposure, Nayan divides the number of stocks he owns on each investment by the total number of shares.
Hence: 200 shares of Company A over 1650 total shares equals 12.12%; 150 shares of Company B over 1650 total shares equals 9.09%, and so on.
Primary components of a diversified portfolio
- Stocks: Representing the most aggressive part of an investor's portfolio, stocks provide the opportunity for high growth over the long run. However, the same high growth can carry even greater risk, especially in the short term.
- Bonds: Providing regular interest income and typically considered to be less volatile than shares, bonds can act as a buffer against stock market volatility. If you are focused on safety, government bonds can help reduce your exposure to equities.
- Money market funds and certificates of deposit: These short-term investments are conservative assets that are stable while offering easy access to your money. These asset classes are vital if you are considering to preserve your principal.
Besides, a diversified portfolio can also contain:
- Sector funds - that focus on a particular segment or the industry in the economy.
- Commodity focused funds - that can work as a good hedge against inflation. Examples of commodity-intensive industries include natural resources, mining and oil and gas.
- Real estate funds.
- Asset allocation funds.
The primary goal of diversifying your shares in the stock market is to reduce your risk. Investing 100% in debt options to cut down risk completely can significantly cut down your overall returns. Hence, as an investor, you can consider growth-oriented asset classes such as equities to enhance your profits. Look to a full-services and well-established broker such as Kotak Securities to be your guide in helping you recognise the right stocks and asset classes for a well-diversified portfolio.