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What is portfolio diversification and why won’t people stop talking about it?

During the 2008 recession, investors took a major hit. Especially those who were completely invested in the stock market. The S&P BSE Sensex had fallen by over 50% between January 2008 and February 2009. However, those investors who had heavily invested in gold enjoyed significant returns during the same period. The gold price went up from $865 to $1100 per ounce. Investors who had a diversified portfolio that included a healthy proportion of both equities and gold, neither gained nor lost too much because the fall in the stock prices was fairly balanced out by the rise in the gold prices. And this is exactly why a diversified portfolio is something prudent investors won’t stop talking about. 

When you diversify your portfolio, you essentially divide up your money into different asset classes to hedge risk. So, if at any one time a specific asset goes down, such as stocks in this instance, a diversified portfolio will lead to lower risk due to other stocks that are performing well. In addition to reducing the risk, a diversified portfolio will also help reduce the variability of investment returns. This means that your income from investments won’t keep fluctuating sharply due to one asset, as different assets will provide returns at different times and ensure some level of investment income keeps flowing. 

So, how do you begin diversifying your portfolio? Here are four simple yet essential steps to get started: 

Choose from different asset classes 

Primarily, assets are divided into the following six categories: 

  1. Equity
  2. Fixed income securities 
  3. Gold
  4. Real estate
  5. Commodities 
  6. Alternative investments 

Out of all these asset classes, equity is one of the most popular. In fact, in 2020, 30% of all individual investments made globally was in equity. That’s because it offers the possibility of earning higher returns.

Diversification works on two levels when it comes to asset allocation. The first includes picking multiple asset classes because not all are impacted by the same economic factors in the same way. For instance, many people prefer to include gold in their portfolio because historically gold has had an inverse relation with equity. As seen in the 2008 recession example, when the stock markets take a hit, gold prices rise. 

The second level of diversification is within the asset class itself. So, when investing in equities, you shouldn’t just invest in three or four stocks that you feel optimistic about. In fact, you should invest in hundreds of stocks to hedge risk. It may sound like an overwhelming task but it’s actually pretty convenient if you invest in pooled instruments like Exchange Traded Funds (ETFs). 

Consider your investment horizon  

Investment horizon is the total period of time that you plan to keep your money invested in a certain asset. Your investment horizon will be different for different assets based on your financial goals and the nature of the asset. 

For instance, if you have a goal that’s short-term such as renovating your home in six months, then your investment horizon for this specific goal will be six months. Since you need the funds soon, your risk tolerance for this goal is lower. This is because short term market fluctuations may not get the time to even out within your investment period. Therefore, it would be prudent to take a conservative approach.  In this case, you might want to keep your money in a  fixed deposit or invest in liquid funds that have low risk, reasonable returns and flexibility of redemption at any time. 

However, with a long-term goal, say buying a second home in 12 years, you have a longer investment horizon so you can afford to take a greater level of risk. You can invest in the stock market in this case because there is enough time for the fluctuations to iron out. That’s why investing in different assets according to your investment horizon will help you meet different goals at different stages in your life. 

Invest in international markets for differential returns 

Just like the weather in all parts of the world is not the same at any given time, the stock market conditions aren’t the same either. That’s because the economic cycles in all countries are not perfectly correlated. So just because the domestic stock market slows down, your investment in another country’s stock market won’t necessarily follow the same trend. Hence, when looking at diversifying your portfolio you should zoom out a little and think beyond India. 

Another thing to consider is the growth of sectors is greatly varied in different countries. For instance, India’s tech sector is nowhere near the US tech sector. The FAANG stocks that comprise the five US tech giants Facebook, Amazon, Apple, Netflix, and Alphabet (Google) have given returns of over 500% to investors over the last ten years. 

To enjoy such returns you should look at including US stocks in your portfolio and you can do so easily with the Appreciate app. With our one-click access, you can invest in over 6000+ companies and thousands of ETFs listed in the US stock market seamlessly. 

Benefit from AI-based recommendations 

Diversification of your portfolio is not a one-time task. But usually, people fail to review and rebalance their portfolio because it can be complicated to constantly keep a watch on the performance of different assets and align them with their financial goals. 

However, you don’t have to do that yourself. With Appreciate you can get AI-based recommendations that identify the right assets at the right time to keep your portfolio balanced always. When your portfolio is in sync with your goals and risk appetite, you will be able to create wealth and build your net worth in your desired timeline.

To know more about how we can help you diversify your portfolio, sign up on Appreciate.

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