What is Portfolio Diversification And Its Importance - Motilal Oswal

What is Portfolio Diversification And Its Importance




Since the price movement in the stock market is unpredictable, investing in it is often considered risky. The forces of demand and supply primarily govern the market movement. The more the demand, the higher the market is likely to move. On the contrary, the more the supply, the lower the market is going to go. As an investor, it is very tough, if not impossible to accurately determine the market trend and invest accordingly. 

While it is impossible to eliminate investment risk, fortunately, there is a way to reduce the risk that you take by investing in the stock market. One of the many ways through which you can manage investment risk is through portfolio diversification. In this article, we’re going to take an in-depth look at what portfolio diversification is and how important it is for wealth creation. Let’s begin. 

What is Portfolio Diversification?  

Portfolio diversification is a technique that involves investing your capital in different asset classes across sectors. Doing so can reduce your investment risk by limiting your exposure to any one type of asset. 

The logic of portfolio diversification is based on the fact that ‘not all asset classes respond to an event in the same way’. For instance, in the case of political turmoil in the country, the stock market may get hit drastically, whereas the bond market may not have that much of an impact. Investing your entire capital in the stock market can lead to heavy losses. On the other hand, if you split your capital evenly between the stock market and the bond market, you can avoid heavy losses. This is what portfolio diversification is all about. 

Importance of Portfolio Diversification  

Now that you’ve seen what portfolio diversification is, let’s take a look at why it is considered to be very important. 

1. It reduces volatility 

Volatility represents swings, both positive and negative, in the price of an asset. A stock whose price moves wildly is said to be highly volatile. Portfolio diversification is designed to protect you from such quick and unpredictable changes in the price of an asset.

2. It limits losses 

The importance of portfolio diversification lies in its ability to reduce or limit losses. When you invest in different sectors and across multiple asset classes, you become immune to losses to a certain extent. For instance, let’s say that you’ve invested in stocks, bonds and commodities. Now, if the stock market crashes but the bond and commodity markets don’t, the losses from the stock market would be offset by the gains from the other two.

3. It enhances returns 

By reducing volatility and limiting losses, portfolio diversification can enhance the returns that you get to enjoy. Additionally, you also get to leverage the growth opportunities present in all the different asset classes and sectors that you’ve invested in. 

For instance, assume that you’ve invested in the stock market, the bond market and the commodity market. Since you have exposure to all three markets, in the case of a bullish run, you get to enjoy significantly higher returns from your portfolio compared to what you would have gotten had you invested in just one market. 

4. It eliminates the need to constantly monitor your portfolio 

As long as you’ve diversified your portfolio properly, you don’t have to monitor your portfolio frequently. This saves you a lot of time and effort which you would have to spend otherwise to protect your investments from the effects of market downturns. That said, you might have to occasionally revisit your portfolio to ensure that its performance is in line with your goals and to maybe do a bit of rebalancing.  

5. It gives you peace of mind 

Investors often underestimate the importance of portfolio diversification. Market downturns and the thought of losing your capital can cause significant emotional stress. When you diversify your portfolio, you impart it with some much-needed stability. This stability will in turn combat the ill effects of market downturns and provide you with some peace of mind.

Conclusion 

With this, you must now be well-versed in what portfolio diversification is. It is a simple, yet important technique that investors should implement to ensure that they stay protected from unexpected market movements. One of the good things about portfolio diversification is that there’s no fixed way to do it. For instance, you can diversify across sectors or industries, asset classes and borders.

The level of portfolio diversification that you need to opt for should be dictated by your goals and your risk profile. So keep that in mind when attempting to diversify. Also, remember that it is impossible to eliminate all risks. Instead, you can only manage it efficiently.  

 

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