InvestorQ : How do I actually go about diversifying the risk in my portfolio? Can you please tell me an example?
Deepa Salunkhe made post

How do I actually go about diversifying the risk in my portfolio? Can you please tell me an example?

vidhya Laxmi answered.
2 years ago

The word diversification tends to be used quite generically. What you actually need to remember is that Diversification itself happens across different levels and you need to address all these aspects to get a truly diversified portfolio. In short you need to diversify across size, across time and across quality. Only then you get the best trade off between risk and returns. Let us look at ways to diversify your portfolio.

The most basic form of diversification is that you can diversify across asset classes. How does that work? It is very simple; you start off by combining asset classes like equities, debt, hybrid asset classes, ETFs, index funds, gold, property, foreign assets etc. This will spread your risk your overall portfolio risk is reduced. Gold and equities typically move against each other and help in diversification. Similarly, debt provides you with stable returns at a time when equities become too volatile.

The general misconception is that you cannot diversify within debt. That is not the case. How to diversify within debt? Broadly there are two ways to do it. You diversify across quality; meaning across AA rated debt and AAA rated debt. When you go for lower quality debt, you get higher returns. Of course, be cautious of the default risk. Secondly, you can also diversify across maturities. Longer maturities are more sensitive to shifts in interest rates compared to shorter maturities. Hence when you expect rates to come down you can weigh your diversification more in favour of the long dated securities.

When you diversify across equities, you don’t just buy any stock at random and keep adding. The game is all about correlations and the lower the correlation with your existing portfolio the better is the diversification. There are a variety of proxies here. How to diversify across equities? The guiding principle is to diversify across sectors, themes and also across market capitalizations. Themes typically cover a number of sectors or sub-sectors and we can have themes like rate sensitivity, rural demand, consumption etc. Remember, diversification has a limit and hence don’t go overboard adding assets. Beyond a point it only results n risk substitution and not risk reduction.

One last word; diversification is one of the core principles of portfolio structuring. From George Soros to Warren Buffett, everyone has to diversify in some form or the other. You cannot diversify systematic risk but you can certainly diversify unsystematic risk.