Many retail investors approach stock market investing by chasing hot stock tips with little planning or research. However, this method ignores the crucial aspect of portfolio diversification. What exactly does diversifying your portfolio mean, and how can you achieve it? This article will briefly explain one aspect of this question: stock portfolio diversification.
What is diversification?
Diversification is a widely used investment strategy where you invest in different types of assets to lower market risk. It’s part of asset allocation, deciding how much of your portfolio goes into different investments. Simply owning a managed product like a mutual fund or ETF already gives you some diversification because they hold baskets of stocks, bonds, or both, reducing the risk compared to owning just one stock or bond.
However, true portfolio diversification means spreading your money across assets that behave differently, not just different individual securities. For example, a NIFTY50 index fund owns many stocks but isn’t as diversified as a global allocation fund, which invests across stocks and bonds in various regions.
Investors commonly diversify across stocks, bonds, and cash equivalents to balance their portfolios. By blending different assets, like stocks and bonds, you reduce the risk of having too much exposure to one type of asset or market sector. There are various ways to diversify a portfolio— within an asset class, across asset classes, and beyond asset classes.
Why is diversification Important?
To grasp portfolio diversification better, consider this example:
Imagine you have Rs.10 lakh to invest. You believe Company A has promising growth potential and decide to put all Rs.10 lakh into its stock. Unfortunately, a regulatory setback causes Company A’s stock to drop by 15%. Since your entire investment is in Company Y, your loss totals Rs.1.5 lakh (Rs. 10 lakh x 15%).
Now, let’s see what difference does diversification make. Instead of investing all Rs.10 lakh in Company A, you spread it across various companies:
- 2 lakh (20%) in Company A
- 2 lakh (20%) in Company B
- 2 lakh (20%) in Company C
- 1.5 lakh (15%) in NIFTY100 index
- 1.5 lakh (15%) in a government undertaking
- 1 lakh (10%) in gold
Now, Company A’s stock still drops by 15%, but others grow by 3% on average. So, your loss would be only Rs.1.05 lakh [(Rs. 8.5 lakh x 3%) – (Rs. 2 lakh x 15%)]. Diversifying slashed your loss from Rs.1.5 lakh to Rs.1.05 lakh, showing how it can safeguard your investments.
How can I diversify my stock portfolio?
You can diversify your portfolio within stocks in four ways-
- Sectoral Diversification:
Different industries and sectors are impacted by the economic cycle in unique ways. To reduce risk, consider investing across various industries. Some sectors, like consumer discretionary (clothing, electronics, cars), financial services, basic materials, and real estate, tend to thrive when the economy strengthens. Others, such as consumer staples, utilities, and healthcare, are more stable regardless of economic shifts.
- Diversification based on market cap:
Market capitalization (market cap) measures a company’s size based on its total tradable stock value (number of outstanding shares multiplied by share price). Larger companies are generally more stable during economic downturns, although they may offer less growth potential compared to smaller firms.
- Growth and Value Stocks:
Growth investing focuses on stocks that consistently grow over time, while value stocks are undervalued and have the potential for significant future returns. Growth stocks are pricier because investors expect strong future growth, while value stocks are cheaper and seen as bargains.
- Diversification based on themes:
Themes differ from sectors by covering multiple sectors. For instance, a theme like rate sensitivity affects industries such as banking, NBFCs (Non-Banking Financial Companies), automobiles, and real estate positively when interest rates decrease. If you diversify based on themes, ensure you are adequately exposed to all of the themes. For example, investing in rural demand could benefit sectors like tractors, two-wheelers, FMCG products, agrochemicals, fertilizers, and hybrid seeds due to higher rural incomes. Plan your diversification strategy accordingly.
Steps to build a diversified stock portfolio:
- To diversify your stock portfolio effectively, include companies from various sectors and industries. Not all sectors perform the same way, so spreading investments reduces risk. Focusing on one industry raises the risk of losses if it falters. Analyze different sectors to find ones that align with your goals.
- Diversify by including companies of different sizes. Market capitalization—calculated by multiplying a company’s shares by its market price—categorizes companies as small, mid, or large-cap companies. Small-cap stocks offer growth potential, large-cap stability, and mid-cap balance. Diversifying across these sizes leverages these benefits.
- Balance your portfolio with both value and growth stocks. Value stocks are undervalued and may rise as their worth is recognized. Growth stocks indicate a potential for significant growth. Including both types spreads risk and avoids over-concentration.
- Mitigate equity market risk with defensive stocks. These belong to sectors less affected by economic cycles, like healthcare or utilities. Their essential products or services stabilize your portfolio during economic downturns.
- Consider international stocks to diversify further. Investing beyond domestic companies reduces risks tied to local economic conditions. Access top global stocks like Meta, Apple, and Amazon through international funds, adding stability to your portfolio.
- Review and adjust your portfolio regularly. Diversification strategies should adapt to changing market conditions and risks. Stable sectors or regions may evolve, impacting your portfolio’s risk profile. Periodic review ensures optimal risk management and capitalizes on new opportunities.
Conclusion:
Diversifying is a fundamental part of investing. It is essential for managing risk and aligning your returns with expectations. However, diversification doesn’t promise returns or shield against losses in a downturn. It’s a proven strategy to mitigate market risks and minimize negative impacts on your portfolio. To use this strategy optimally, consult a SEBI-registered investment advisory who will help you build a portfolio tailored to your financial goals.
FAQs:
- What is the 80:20 allocation ratio in diversification?
Aggressive investors who can handle high risk often split their investments using an 80:20 allocation ratio. They put 80% of their money into stocks and 20% into bonds.
- What is an ideally diversified portfolio?
An ideally diversified portfolio invests in various asset classes with minimal exposure to any single security. This way, if one security performs poorly, it won’t significantly affect the overall return. Such portfolios generally mirror market returns.
