Risk Mitigation Through Diversification: What Does it Mean?

The age-old advice ‘Don’t put all your eggs in one basket’ applies to many different aspects of our lives. But it is the foundation of every successful investment journey. You can find several successful investors who have stuck to this principle over the years and reaped great benefits.But what does this advice mean? Not putting all your eggs in a single basket basically signifies the importance of diversification. It means that you should never invest all your money in a single asset or even a single asset class. Mitigating investment risk is one of the primary objectives of diversification.Let us have a look at how diversification works in the real world of investment-

Diversification is all about managing your investment portfolio so that the risk exposure is kept to a minimum.As one of the fastest-growing countries globally, there is no lack of investment options in India. There are many different ways to invest from traditionally popular choices such as Fixed Deposits (FDs), gold, and real estate to equity, bonds, and mutual funds.While there is no denying that you should select an investment vehicle based on your investment objective and risk appetite, you cannot expect your portfolio to generate handsome returns while also keeping the risk to a minimum by investing in a single asset.So, diversification is an investment ideology which suggests that you should consider different non-related assets in your portfolio. For instance, let us assume that you have FD, equity, and gold in your portfolio. If the equity markets fall, your investment in FD and gold can balance out the risk and protect your portfolio from taking a huge hit.

As mentioned above, diversification is only an investment ideology. Investors are free to modify it as per their goals and requirements as long as they stick to the core idea of not investing all their money in a single asset.Now, assets can be related or non-related. For instance, your investments in shares of different companies are related as all shares ultimately rely on the equity market. If the equity market is falling, there is a possibility that your investment in different shares can fall too.On the other hand, you have investment options such as FD, equity, real estate, and gold that are not related to each other. The FD rates will not change if the equity markets are falling, or the gold prices will not fluctuate based on the real estate sector.Similarly, there are correlated assets that are not directly related to each other. For instance, if the equity markets are falling due to the slowing economy, the RBI can reduce the interest rates to stimulate the economy. Many assets, such as bonds, are co-related to the interest rate.So, any kind of interest rate change by the RBI can impact the returns you can generate from your bond investments.

It is generally recommended that you should try to build a portfolio that has multiple non-related assets. Even within these assets, you can go ahead and diversify further.To give you an idea, let us consider that you want to invest in equity. So, rather than investing all your money in shares of a single company or companies belonging to the same industry, you can create a basket of small-cap, mid-cap, and large-cap stocks from different industries.Let us consider that you have selected a few good stocks from the IT, Finance, and Consumer Goods sector across market capitalizations.So, if the IT sector is not performing well, your investment in shares of Finance and Consumer Goods companies will try to balance out the risk level of your portfolio. By doing this, you will be able to mitigate risk and benefit from the growth of multiple industrial sectors.

Here are a few tips that can help you create a diversified investment portfolio -

• Consider Assets Based on Risk Profile By only investing in multiple high-risk assets, the inherent risk level of your portfolio will be very high. Similarly, if you only invest in assets that are low on risk, the returns would probably not be very impressive. So, every investor should look for a combination of high-risk, moderate risk, and low-risk assets for their investment.The ratio or percentage of your investment amount that you should commit to assets of different risk levels can depend on your objective and risk appetite. For instance, if you are a young, aggressive investor, 50%-60% of your portfolio can be equity (high-risk), while the rest can be divided between hybrid funds (moderate risk) and bonds or FD (low-risk).
• Adjust the Portfolio Regularly Diversification is not a one-time process. If you have successfully created a diversified portfolio, you cannot stick to the same portfolio throughout your life. You will need to track your portfolio and make timely adjustments for risk mitigation and improve the returns potential.For instance, let us assume that you have reasons to believe that the equity markets are about to fall in the following months. So, you can sell some portion of your equity holdings and invest the same in other assets such as debt funds or bonds.Even within the equity market, let us consider that the IT sector is not performing as expected. You can reduce your exposure to this sector and invest in companies from other sectors. But ensure that you only make changes in your portfolio when you have solid reasons for such adjustments.
• Focus on Taxation Another vital aspect of building a diversified and profitable portfolio is taxation. All the different types of assets are taxed differently. For instance, your investment in FD will be taxed very differently as compared to your investments in equity. Another example is mutual funds, where equity funds are taxed differently than debt funds.If you are aiming for tax-saving investments with higher returns potential, you can consider ELSS (Equity Linked Savings Scheme) funds that are eligible for tax deduction under Section 80C.
• Consider Professional Assistance If you are new to the world of investments, it is always better to consider professional assistance than trying to do everything on your own and risk your hard-earned money. Professional investment advisors can help you by creating a portfolio that is not only diversified but in line with your risk appetite and investment objectives.Their knowledge and experience can help you with risk mitigation while also increasing the returns potential of your portfolio.

Diversification is the key when it comes to mitigating risks and protecting your investment. Work on an asset allocation strategy as per your investment objective and risk appetite so that your portfolio is able to help you get closer to your financial goals.Diversify beyond the traditionally popular investment vehicles as there are now options such as mutual funds where you can find schemes that perfectly match the investment objectives of every investor. Do consider the tax aspect when selecting an asset and take professional help in case if you are unable to build a well-diversified portfolio on your own.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.