InvestorQ : How do you diversify an investment portfolio?
varsha Motwani made post

How do you diversify an investment portfolio?

Ask IIFL answered.
11 months ago
Diversification allows for minimizing the risk associated with any investment while allowing for sizable returns. For this, you need to invest in assets that are not vulnerable to one or more kinds of risk. For eg:  

a) Reducing economic risk by diversifying between cyclical and non-cyclical investments
b) Reducing asset class risk by investing in more than one asset class.
c) Reducing industry risk by dividing your investments between different sectors.
d) Reducing company risk by not concentrating your investments on just one or two companies.

Now that we have understood the need for diversification, let us understand the process for diversifying a portfolio. When it comes to building a portfolio, some individual investors focus on selecting the right fund manager or security. Planning your investments with a financial adviser, rather than taking an ad hoc approach, has the potential to help you reach your investment objectives successfully. However, manager selection forms only a small part of the process. At a broader level, portfolio construction should be about structuring your portfolio in a way that stands the best chance of meeting your stated investment aim within your acceptable level of risk. Though it will be difficult to comment or advise for a specific portfolio, there are certain thumb rules that can assist in building the right portfolio- 

a) Several studies have shown that the most important decision when constructing a portfolio is asset allocation. This means ensuring your portfolio has the right balance of assets to suit your financial goals, investment aims and risk appetite. A key part of constructing your portfolio is understanding your comfort to various levels of risk. Once you have gauged your risk appetite accurately, you can decide an allocation that offers you the optimum returns within your level of risk.

b) In order to reduce your risk, you need to spread your portfolio across a broad mix of assets. Diversifying your portfolio can help neutralize market ups and downs- such that returns from better performing assets help to offset those that are fixed yet stable assets.

c) Invest based on your goals which means align your asset mix to your goals accurately. Equity or equity related schemes work better in the long term. So, it is beneficial to peg your long-term goals (eg-retirement) to these assets.  

d) For effective asset allocation, professional investors often seek to combine assets that tend to do well at different times. 

e) Using an asset allocation strategy helps free you from the risk of following temporary investment trends. Having a formal strategy can help by ensuring that your portfolio stays balanced.

f) Passive funds, often called index or tracker funds, can make a useful addition to your overall portfolio.  It’s possible to select a range of uncorrelated active and index funds in an effort to cushion the volatility related to your portfolio.