How to Diversify Your Portfolio- Definition and Example

Many people with substantial wealth often need to pay more attention to the critical concept of portfolio diversification. Despite having financial gains and witnessing flourishment in their investments over time, some investors mistakingly believe they know the critical principle of wealth accumulation. However, the key principle behind this is the degree of diversification in the overall portfolio. Diversification is not limited to assets like stocks, bonds, or certificates of deposit. Instead, a broader approach is applied to sectors, time, and geographies. Read further to learn how to diversify your portfolio.

1. Diversification is a strategic approach to diversifying a range of investments in a portfolio to mitigate overall risk.

2. It is more than diversifying asset classes. Rather, it involves investment in countries, industries, company sizes, and tenure.

3. Portfolio diversification involves investment in risk-free, low-risk, medium, and high-risk investment options.

Easy Defination

Portfolio Diversification means investing your money in stocks, bonds, and cash; you can also categorize these in the industry, funding strategy, creditworthiness, and geography.

Portfolio Diversification Example:

Let's assume you have invested your money in Google stock. Google is a technology company, and your asset allocation is 100% stock. If Google stock prices go down, your investment portfolio will also suffer. Investing in various sectors to protect your portfolio from market downs will be a good practice.

Why is Diversification of Investment Portfolio Necessary?

Don’t bet the farm on one horse, and Our economy runs in four stages: Prosperity, Recession, Inflation, and Deflation. Depending upon each other, these stages provide immense wealth sometimes and drain the wealth many times. Economic shocks like Corona sometimes impact the investment so badly that the investor is left with red in his portfolio. Why this happens, and what should be done? Once again, it is true to say don’t bet the farm on one horse. The simple strategy to keep your investment portfolio balanced is to diversify it. Isn’t that simple? 

We have seen that during the pandemic, the shares of pharma companies were touching their higher highs. But what about others? The supply chain completely hindered the growth of the economy, which badly impacted other companies. This was not the end. The Russia-Ukraine war emphasized the importance of defense products, and every country started to build their attack and defense. This war provided the opportunity for defense companies to step onto the fields. Again! What about the others?

These two incidents taught us the importance of diversification of portfolios. But how can it be done?

5 Rules of Investment Portfolio Diversification

1. Make room for your investments

When you don’t wear the same dress on different occasions, why should you invest in the same sector when the economy drives you through different stages?

You are provided multiple investment options like Shares, bonds, FDs, mutual funds, gold, crypto, and whatnot. They all have their own characteristics, importance, and drawbacks. When one fails to give you a proper return, the other helps you back up. And that is what you need.

Even if you select the same asset shares, you have different industries and sectors to explore. It is evident that bonds and equity markets have opposing relationships. It is good to have both in your basket. Any negative movement in one will provide positive movement to the other. 
It is called a situation with a winner and a loser.

2. Index or Bond? Well! Why not both?

To diversify your fund in a sound manner, adding index and bond funds is a great strategy. The benefit of index funds is that they are highly cost-effective. On the other hand, bond funds are good for hedging. They provide a shield from market volatility. They are lower-risk investments. 

3. More is never less

The idea behind the statement is to keep building up the portfolio. If you want to enjoy the volatile ride, keep investing in different assets, equities, debts, or other instruments.
Bearish market offers investors the opportunity to add more to the portfolio. If you wait for the market to go up, wait for it to come down, and don’t miss the chance to invest.

4. Balancing the imbalance

If you habitually add more to the portfolio, that’s great! But it is always good to complete your occasional task. The task of checking up on your portfolio. Diversifying simply means balancing. Next time you check your portfolio, give a thumbs up to your strong performers and keep an eye on the worst ones.

5. A tough lesson

It is good to have an idea about short-term and long-term volatility. Some assets are good to absorb the shock of the economy, while some fail miserably. Companies with strong fundamentals are capable of absorbing even the long-term shocks of the economy, and they rebound with great force. You must find those investments in your portfolio that cannot withstand the shock of the economy and bid farewell.

Diversifying doesn’t mean you can build a loss-proof portfolio. Rather, it means you are efficient enough to cushion yourself from any major loss. It helps you to find the balance between risk and return.

What are the different types of portfolio diversification? 

Portfolio diversification means choosing different methods and selecting a particular approach that aligns with the objectives. The decision to diversify depends on understanding, knowledge, and experience in implementing different diversification strategies. Here are the different methods to diversify your portfolio. 

1. Industry diversification

In industry diversification, investors incorporate industries that exhibit negative correlations or have different risk profiles. This approach is specifically designed to enhance resilience against the market cycle. This approach is often used in thematic investing, where investors focus on broader themes instead of specific sectors. It involves industries like real estate, cement,  power, and steel, which provide diversification across these areas. The aim behind this strategy is to capture growth opportunities and reduce risks that are associated with a single sector.

2. Individual company diversification

It is the most common approach to diversification, which involves analyzing investment at the individual level of the company. In this method, the investors look for each company's fundamentals and operations to identify those with potential negative correlations. In this method, the individual or investor understands the strengths and weaknesses of the company and builds a portfolio where the individual company's performance may move in the opposite direction under different market conditions. In this method, an investor builds a sound balance portfolio, combining other companies that perform differently in different market scenarios.

3. Time diversification

The best example of time diversification is a systematic investment plan. Time diversification is achieved through regular, systematic investment over time. This method is effective in navigating the volatility of the market. With time diversification in the portfolio, investors can use exchange-traded funds to achieve a well-rounded risk reduction strategy.  ETF provides diversification across various companies within a particular sector or theme.

4. Geographic diversification

Geographic diversification means investing in developed economies or emerging markets where investors can mitigate the impact of economic and currency uncertainties. Investing in developed economies exposes the investor to a stable and mature market with an established regulatory framework. It also reduces the risk associated with political and economic stability. On the other hand, investing in emerging markets has the potential for faster growth and higher returns, but that also comes with higher volatility. 

What is considered a good diversified portfolio?

According to research, a well-diversified portfolio involves around 20 to 30 stocks with effective risk reduction. However, adding more security can provide diversification benefits, but the effectiveness can significantly diminish. The primary goal of diversification is to reduce the unsystematic risk event in the portfolio. Therefore, it is essential to invest across different assets so that some investments' positive performance can offset others' negative performance. 

It is also essential to understand that the security in the portfolio could be more perfectly correlated. It means they should respond differently in opposing ways per the market condition. A good diversified portfolio is a balanced portfolio that reduces the risk of one investment over another.

Final Word

Portfolio diversification is a critical strategy for investors seeking to manage overall risk and enhance the performance of their portfolio. Diversification means more than spreading investment across different asset classes. It involves considering factors like industries, individual companies, time, and geography. A balanced, diversified portfolio responds differently in different market conditions and aims to minimize the investment risk.

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