Dictionary meaning of diversification is – having variety of character or form or components; or having increased variety
It is a familiar term for many investors. In a nut shell “Do not put all eggs in one basket”. An investor diversifies his portfolio as a vital part of financial planning and also to maximize return on capital. One can diversify his investments into different shares or different asset classes like real estate, bonds, gold, bank deposits etc. When one asset class fails to give proper returns it is balanced by another asset class. For example, when stocks are moving down gold moves up and vice versa.
We will see the advantage of diversification and how we can profit by diversifying our capital and minimizing (containing) our risk.
- Economic crises – Portfolio diversification can prevent you against the risk of economic crises (mostly during external aggression or war). When financial market crashes (Lehman Brothers) suddenly assets like gold are seen as safe heaven to park your investments. And when the bull market is on run assets like stocks give a good return on your investments as compared to gold. So if you have diversified into gold and shares your loss in one asset class is covered up by another asset class. Diversification can be used as a safety net.
- Tax advantage – It is a great way to save taxes on profit earned. Investment in stock for more than one year is not taxed. Similarly, there are tax saving mutual funds (3 years lock-in period). Also, deposits in PPF (deposit, accrued interest, and withdrawal, 15 year period) are also tax-free to the certain extent. So diversifying your portfolio into stocks, mutual fund, and PPF (and many other) you can save on tax from your investments.
- Sectorial advantage – When the government announced schemes/policy like home for all, affordable housing, decrease in housing loan interest rates, etc construction sector will get the boost. As part of a diversified portfolio if you have shares of companies dealing in construction and allied field you will get good returns on investments. Trump’s announcement gave the boost to American IT sector companies and demoralized Indian IT sector. How to make money in Indian stock market and in which sectors to invest in so as to diversify your risk to the minimum.
You can diversify your share portfolio across various sectors like banks, cement, automobiles, pharma, telecom, energy, IT, FMCG, consumer goods, metals, media, and entertainment etc, and also across large, mid. small micro and mini caps, that is market capitalization. See Indian stock market overview for more sectorial details.
- Overexposure – One should not be overexposed to one sector or asset class. Say you keep on regularly buying shares of one company says ABC which is in pharmaceutical sector deriving most of its revenue from the USA. Now USA changes its policy and ABC cannot sell to the USA and suffers the huge loss. Since you have been accumulating shares of ABC for a long time your return on investment wipes out. There are many myths about Indian stock market which should be dispelled among the general public. Across asset class, those who have invested their lifelong income only into reality, because of demonetization, RERA, other policy have suffered a huge loss on their returns. Had the investor diversified into shares, gold, bank deposits etc. he would have lessened the loss on return. One should know when to sell shares to make profit.
Purpose of diversification is to minimize risk and provide meaningful gain, so as the financial goals are achieved and can have a comfortable retirement and a life one dreams of.