What do we understanding by diversification of risk? As you spread your money across more asset classes your overall risk is reduced. The logic is something like this. When you have some assets that benefit if interest rates go up and some assets that benefit when rates go down then you may forego some returns in the process but your long term risk will sharply reduced. It is always better to spread your risk rather than put all your eggs in one basket.

There is something unique that we need to understand about diversification. It is not just a random spreading of your portfolio across asset classes. Diversification is all about spreading your assets judiciously in such a way that your risk is reduced. Warren Buffett has always been a great critic of too much diversification. He believes that the dividing line between diversification and over-diversification is too thin. As a result, more often than not, diversification ends up being a form of Diworseification. How to ensure that diversification is meaningful in reducing your portfolio risk.

The 8-step checklist to ensure meaningful diversification of risk..

There has to be a limit on the number of unique assets you diversify across. Let us take the case of an equity portfolio. While there are no hard and fast rules, diversification is said to work when you add up to 15-16 stocks to your portfolio. Until that point, there is incremental benefit in adding more asset as the overall risk comes down. Beyond that point the marginal benefit starts shrinking till you reach a point where each additional stock only substitutes risk rather than diversifying risk. Keep your portfolio of stocks within the limit such that diversification is actually reducing risk.

Diversification has to be across low correlation assets. If you are holding on to a stock and add another stock that has a correlation of “1” with the previous stock then there is unlikely to be any diversification. Every additional stock should have a correlation of less than 1 with the existing portfolio. Only then it reduces the risk of the overall portfolio. In fact, lower the correlation with the existing portfolio, the better the asset is.

Diversification across sectors normally tends to work quite well. Unlike a sectoral fund, the equity diversified funds will spread their risk across a variety of sectors. So when a few sectors are outperforming, there are a couple of sectors that are stagnating and a few sectors that are underperforming. Overall, the performance of the portfolio betters the market index. Specific sectors in your portfolio may have down-cycles but overall your portfolio is protected.

Diversification is also about spreading your assets across themes. You may believe that you have diversified your portfolio across banks, NBFCs, auto and reality. While these are distinct sectors they are all vulnerable to a rise in interest rates. That means if the rates go up, as is likely right now, then all these 4 sectors will perform badly leading to portfolio underperformance. Hence your diversification needs to be evaluated across themes apart from sectors.

When you diversify be cautious of dragging down your returns. A classic case is diversifying your portfolio by investing in gold. Gold is a very good hedge in troubled times. The problem is that gold as an asset class has traditionally been a gross underperformer. If you diversify your portfolio with a 7-8% exposure to gold then it is understandable. However, if you shift to gold to the extent of 25-30% then there will be little additional benefits but then the returns will take a serious hit. That is something you need to keep in mind while diversifying.

Diversification should still be done within the contours of your long term financial plan. When you diversify, there will be a shift in your asset mix. However, your mix must not go too far from the original mix as envisaged in your long term financial plan. After financial plan is all about discipline and it is likely to be successful only as long as that underlying discipline is maintained. You cannot forsake that discipline even for the sake of diversification.

Diversification should be an ongoing process. Let us understand this better. The overall market may have shifted from being a stock-picker’s market to a macro market. In such cases you may be better off investing in an index fund rather than in an active fund. Not only that the underlying stock structures change but even underlying correlations among stocks keep changing. Hence you need to follow a dynamic diversification policy to ensure that you do not end up being over-diversified or under-diversified.

Lastly, be cautious on international diversification. This can be done through international assets or through international ETFs. These products run a huge currency risk so you may end up being exposed to currency fluctuations and to cross-currency volatility. In the process you may end up over-diversifying and adding on new kinds of risks without any concomitant benefits.

Diversification is a must to reduce your overall risk. Be careful not to over-diversify as it could defeat the essential purpose of reducing your risk!