The fundamentals of diversification

Diversification is made out to be a panacea against the risk of volatility, be it volatility in prices of stocks on the stock markets or volatility in interest rates in debt market. But diversification is a broad concept that needs to be understood thoroughly by the investors. So let’s try to understand what is meant by diversification.

For an equity and equity-fund investor, diversification would mean investing in companies from diverse sectors and industries such as banking, IT, FMCG, power, steel, engineering, auto, cement, among others, as well as companies with different market capitalisations, viz. small-cap, mid-cap and large-cap. Such diversification across sectors, industries and market caps helps mitigate market risks to a large extent. This is because a downturn in one sector might be offset by an upturn in another sector or a sharp downturn in small-cap and mid-cap stocks might be cushioned by steady prices or limited decline in large-cap stocks. Of course, an investor who chooses to diversify only in equities in the aforesaid manner will be exposed to equity market risk when the market crashes due to some calamitous event. In which case, the investor’s entire equity portfolio may show a huge loss. Hence, diversification within a single asset class (such as equities) may not help in mitigating market risk as such a portfolio carries an inherently higher risk.

An investor who chooses to diversify across different asset classes would reap the benefits of broad-based diversification. An investor might invest in various asset classes such as equities, gold. debt, real estate, etc. All these assets have different levels of risks attached to them, where equities carry the highest risk while real estate may carry the lowest risk. The prices of equities and gold fluctuate on a daily basis, while the prices of real estate may vary on a quarterly, half-yearly or annual basis, depending on the demand-supply scenario of residential and commercial properties in the locality, area and city. The movement in prices of bonds will depend on the movement of interest rates, which in turn depend on various macroeconomic factors. As interest rates do not move up or down on a day-to-day basis, the risk associated with debt investments is comparatively low. Therefore, an investment portfolio comprising of equities, debt, gold and real estate is widely diversified and provides adequate cushion against negative movement of prices in one asset class with steady prices or positive movement in prices of other asset classes.

The different kind of mutual fund schemes available in the market provide ample scope for diversification as mutual funds invest in different asset classes, including equities, debt, gold and real estate. While the equity-oriented MF schemes invest a large portion of the corpus in equities and a small portion in debt, the debt-oriented schemes invest only in debt instruments. Then, there are thematic MF schemes that invest in themes such as such as housing, banking and financial services, infrastructure, etc. Also, there are other mutual fund schemes that invest in gold (gold ETFs).

Hence, depending on the risk appetite, return expectations and financial goals to be achieved, investors can pick and choose between various asset classes to build a well-diversified portfolio of investments.