Diversification of Portfolio:

As we know, each investment or asset type has a certain amount of risk connected with it. Generally, the equities are considered to be most profitable investments over the long run. At the same time, they are famous for the high risk associated with them. The risk does not only vary by investment option (like stocks, bonds etc.) but it also varies under each investment category. For instance, the shares for infrastructure sector may be riskier than the ones in banking sector. It is believed that higher the risk, higher is the return. But you, as an investor, might not be ready for a higher risk and might not want to compromise on your return either. In that case, Diversification of your portfolio can help you in reducing the level of risk and fetching the same returns on your investment too. The diversification works as follows:

Suppose you want to invest Rs.1 lac for buying stocks and you the following options:

Option 1: Invest in stock A that has an expected return of 15% with a standard deviation (risk) of 20% i.e. you have 80% chance of making 15,000 if you invest your money in Stock A

Option 2: Invest in stock B that also has an expected return of 15% with a standard deviation (risk) of 20%.

Both Option A and B are from different sectors and are not correlated. That means, if you choose to invest your complete amount in one of these sectors, then your funds are equally exposed to similar risk. Whereas, if you divide your investment value into equal portions of Rs.50K each, then you are spreading your risk associated in each class. For example, if after a few days, something goes wrong with stock A sector, then you are still on a little safer position as the stock B is not correlated with any market tabulations in stock B. And if everything goes well, then you are anyways getting equal return of 15% from both the sectors. So your overall return remains the same and only the risk gets distributed.

In this way, diversification of your funds allows you to divide the risk and play your game safely without compromising on your return.

Need to diversify your portfolio:

Whenever you invest funds, you are always exposing your money to certain amount of probability. The risk, however may range from low to high depending upon the type of investment. Highly profitable investments like stocks may be relatively riskier than the safe but low yield FDs and Bonds. The investments usually have following combinations:

Low risk-> low but certain yield; low but fixed return; low but steady returns

High Risk-> high but uncertain return; variable but with exponential growth

Medium Risk-> Medium/Low but fixed return and many more.

The primary objective of an investment should be to make profit after preserving the principal or actual money invested. So as to attain this goal and earning a reward on your portfolio, you should follow following golden rules:

Rules of Investment

It is always advisable to verify the below mentioned check-points before you make any investment decision.

1.Know your risk-appetite: Before you jump into any investment, you should always do a self-analysis about your risk appetite and risk tolerance. Your risk appetite determines your readiness for taking a risk whereas your risk-tolerance determines your ability and sustainability to do so. You should ask yourself a few questions like- What if market falls and I lose my principal invested? Will I be able to survive the risk of losing this amount of money? Will I be able to take the risk with a lesser amount of funds? What other alternatives do I have for investing my funds? Etc. Your age, experience and knowledge contributes a lot to your risk taking ability. As the risk taking ability reduces with the age on the one hand, it increases with experience and knowledge on the other hand.

2. Do not put all eggs in one basket (Diversify): Diversification is the key to reducing the risk associated with any investment. As the “location” is the most important criteria while buying a property, similar is the case with investing your money in market related funds too. As the returns are uncertain, the risk can however be reduced once you diversify your portfolio of investment. The Fund advisers always advice their clients to diversify their portfolio of investment ranging from low, medium risk to high risk investment vehicles. Your investment should be an assortment or range of investment vehicles, to spread the risk of possible loss due to below expectations performance of one or a few of them.

3. Increase your Financial Literacy: Improving your financial knowledge helps you to understand various investment options available in the market and enable to you cherry-pick the best alternative that works for you. Being well versed with financial products not only gives to confidence to invest but it also saves your time, money and effort involved in seeking financial advice.

4. Risk vs. Return: Always do a Risk vs. Return Analysis before you invest! Identify the standard deviation i.e. risk associated with a particular investment vehicle and its potential return. This helps you in determining the percentage of debt and equity exposure you are comfortable with. Studying about a particular investment and its sector further helps while taking any investment related decisions.

5. Liquidity Needs: Everyone needs liquid funds but the amount and timing for liquidity varies and depends on individual’s lifestyle, family expenses, contingency planning etc. Before you invest in any long term funds, you should always analyse your future requirements or any expected upcoming event (like wedding, college education of children etc.) that demands you to be cash rich.