You must have heard the popular piece of wisdom, “Don’t put all eggs in one basket”. The idea is that if the basket falls then all the eggs get damaged. That is the basis of diversification of risk. Basically, you spread your risk across asset classes to make your job easier. In technical parlance we also call it diversification but it is all about spread your risk across assets with less than perfect correlation. The idea is that even when some assets are underperforming, there are others that are doing better. Risk is everywhere. There are risks in taking a job, there are risks in starting your business and there are risks in investing your money. The idea of not putting all the eggs in one basket is to ensure that the overall risk is managed better and even in a worst case scenario the investor has some positive returns to fall back upon. Diversification improves your risk adjusted returns.

Let us consider a portfolio illustration. When you invest all your money in steel stocks and if Chinese demand for steel goes down then the price of steel on the LME could fall sharply. That could lead to sharp losses in your portfolio as all the steel stocks are likely to react negatively to such news flows. A better way to manage your risk is to diversify. Instead of holding all your investment only in steel stocks, you can buy oil, IT and banking stocks so that your overall risk is better managed. You can diversify your risk across asset classes, across specific assets, across themes and also across sectors and maturities.

Why is diversification so important? The primary goal of diversification is to reduce risk and not to maximize profits. It works like this. In fact, diversification is a trade-off. You are giving away some part of your return so that risk can be reduced. That effectively improves your risk adjusted returns. If you invest in asset classes that do not move in the same direction, at the same time or at the same pace, then you will reduce your chances of losing all of your money at the same time. Take the case of the financial crisis of 2008. If you had spread part of your money in equities into gold in 2008, then your losses on equity would have been partially compensated by the positive returns on gold and your portfolio would have done much better over a 3 year period. The impact of diversification is normally felt in good times but surely felt in bad times.