Diversification - Why you should use it now

The word of 'Diversification' seems long but it is not really complicated.

It just builds on the famous saying - "Do not put all your eggs in one basket"

In simple terms, diversification means spreading your investments so that your exposure to any one type of asset is limited.

But why do investors fear diversifying?

For starters - because they do not know anything about it.

But before we dive into it, we must first accept the fact that the market is unpredictable. No one can predict what will happen in the market tomorrow, and if anyone claims to predict that – they are either lying or are God.

So, the next best thing is to work with probabilities.

And here is where diversification helps. It reduces the volatility of your portfolio over time.

Why diversify?

One of the keys to successful investing is learning how much risk you can tolerate in comparison to the returns you want.

Invest your retirement nest egg too conservatively at a young age, and you run the risk that the growth rate of your investments won't keep pace with inflation. On the other hand, if you invest too aggressively when you're older, you could leave your savings exposed to market volatility, and run the risk of eroding your assets at an age when you have fewer opportunities to recoup your losses.

The primary goal of diversification is not to maximize returns. Its primary goal is to limit the impact of volatility on a portfolio and help you sleep better.

I would definitely not trade my good night's sleep for any amount of returns. Would you?

How to diversify?

Financial advisors can make it complicated but at its root, it is the simple idea of spreading your portfolio across several asset classes like equity, mutual funds, debt etc.

Even within those asset classes, you should diversify within sub-classes.

Talking about equity, you can diversify by purchasing assets of companies in different industries.

For debt, you can diversify between bank deposits, corporate bonds, government securities etc.

How diversification can help reduce the impact of market volatility

A study in the USA is a good example on the benefits of diversification. Look at the charts below, which depict hypothetical portfolios with different asset allocations.

The average annual return for each portfolio from 1926 through 2015, including reinvested dividends and other earnings, is noted, as are the best and worst 20-year returns.

The most aggressive portfolio shown comprises 60% domestic stocks, 25% international stocks, and 15% bonds: it had an average annual return of 9.65%. Its best 12-month return was 136%, while its worst 12-month return would have lost nearly 61%. That's probably too much volatility for most investors to endure.

Changing the asset allocation slightly, however, tightened the range of those swings without giving up too much in the way of long-term performance. For instance, a portfolio with an allocation of 49% domestic stocks, 21% international stocks, 25% bonds, and 5% short-term investments would have generated average annual returns of almost 9% over the same period, albeit with a narrower range of extremes on the high and low end.

As you can see when looking at the other asset allocations, adding more fixed income investments to a portfolio will slightly reduce one’s expectations for long-term returns, but may significantly reduce the impact of market volatility. This is a trade-off many investors feel is worthwhile, particularly as they get older and more risk-averse.

Regardless of your goal, your time horizon, or your risk tolerance, a diversified portfolio is the foundation of any smart investment strategy.

History is witness to this fact.

Thank you for reading.

Feel free to reach out in case of any questions.