So, should we be carrying out this so-called "portfolio diversification" then? In this article, I will breakdown what portfolio diversification actually means and for who this strategy would be valuable.
Portfolio Diversification - stands for the process of minimizing your risk by investing across several asset classes instead of investing all your savings in a single asset class. Investing your savings in a single asset class makes you vulnerable to the lows of that single asset. As a way to hedge yourself against its vagaries, you can employ the strategy of portfolio diversification.
Why is Portfolio Diversification important? - Historically, the price of bonds moves in the opposite direction to the price of stocks. The same is seen with the price of gold moving in the opposite direction of stocks. This happens whenever there is a hint of a weakening economy. At this point, there is a tendency to buy safer, minimum risk assets like bonds or gold resulting in an increase in the prices of bonds or gold while the price of stocks decreases.
Now imagine all your investments are in stocks and the prices of stocks falls by 5%, so your portfolio is now down 5%. However, for example if you have an equal mix of stocks and bonds and stocks fell by 5% and bonds went up by 1%, your total portfolio is down 2% instead of being down 5% when your portfolio was made up of only stocks. You can immediately gauge the importance of portfolio diversification, as it is an excellent tool to minimize risk.
What you thus end up doing, by mixing and matching asset classes that have a negative or low correlation to each other, are to ensure that you can contain the losses on your portfolio and minimize risk. This is why we at TriVest Folio (www.trivestfolio.com) provide a framework where you can choose different asset classes at the time of constructing your portfolio that would allow you to gain the benefits of diversification.
Is Portfolio Diversification good for you? - Portfolio diversification provides great benefits when it comes to minimizing portfolio risk but is it a good strategy to follow for you? Warren Buffett doesn't necessarily believe in diversification and he has become a billionaire several times over so shouldn't we be following his footsteps?
The truth of the matter is that it depends on your need! For busy working professionals who do not have the time and energy to invest in completely understanding financial instruments, portfolio diversification provides a great way of minimizing risk. The goal of portfolio diversification is not to boost performance but a simple way to ensure that you do not lose your shirt in tough times.
The key to successful investing is to be disciplined in your approach and portfolio diversification is one way to ensure that you invest your way to slow and steady success.
Sandip Southekal is the Co-Founder of TriVest Folio (www.trivestfolio.com) a personal investment tool to help build a diversified portfolio of Mutual Funds and ETFs.