Are you a first time investor?
A sound portfolio is the first step to help you grow your money over a period of time. There will be some time and effort that will be required to construct a good portfolio. Diversification of the portfolio should be one aspect that should remain at the forefront in its construction. Diversification will also help in the reduction of risk and that is something that first time investors would benefit from. Attaining this would require some efforts as well as a new thought process and this is something to aim for.
Diversification
Diversification is the process of spreading out the investment amounts across different areas so that there is a lesser chance of all of the investments behaving in a similar manner. Diversification will ensure that there is a lesser chance of all the investments in the portfolio moving together. This reduces the extent of the changes in the portfolio and consequently reduces risk.
Diversification is also a way to inject certain type of behaviour to the portfolio because using just one type of asset or investment would mean that if something goes wrong in that area there would be a significant impact on the overall portfolio and performance. As more and more investment options are introduced there is a tendency for some of them to behave differently which will reduce the extent of change in the portfolio. A very good example is for a first time investor like you to spread their money across fixed deposits, bonds, equities and have some liquid amount as cash. This is diversification as compared to a situation where you just have equities in the portfolio or just debt instruments like fixed deposits.
When all your money is in a single area like equities and the stock markets are weak then there will be a negative impact on your entire portfolio. On the other hand by having some money in fixed deposits and bonds there will be less volatility in the overall investments and at the same time there is also some regular income flow that is not dependent on just the performance of the stock market.
Example of a portfolio of a 45 year old individual spread out across different asset classes
Types of diversification
As a first time investor you need to have certain guidelines that will direct your efforts towards ensuring effective diversification for your portfolio. There are different ways in which this can be achieved so you have to ensure that on an overall basis there is effective impact of the effort to diversify.
Asset classes
One of the best ways to diversify your portfolio is to actually have an exposure to multiple asset classes. It is not a good idea to have just a single asset class in your portfolio so on one side only real estate in the portfolio can lead to a high level of risk but at the same time there is also a significant risk if all the money is in fixed income or debt instruments.
If interest rates decline significantly then there is a chance that if you have only fixed deposits then you will be hit disproportionately hard as these come up for renewal. A very good example has been seen of people who retired in the late nineties and invested the entire amount of their retirement money in debt instruments like bonds, debentures and fixed deposits.
At that time they were earning 15-16 per cent interest but after a few years they found themselves in a tough spot as the average rate fell to around 7-8 per cent. Having different asset classes like equities, commodities, debt and some amounts in cash can ensure that changes in one area will not have a disproportionately higher impact on the overall financial position.
Example of how excess exposure to debt instruments can lead to risk if returns fall
Individual holdings
If there are a small number of holdings in the portfolio then you run the risk that changes to a few of them would determine the manner in which the entire portfolio would move.
The way to tackle this position is to have a larger number of holdings wherever the investment is being made so that the impact of a sudden change can be minimised. If you are investing in equities then you should ensure that there are not just 3-4 shares but a larger number like 15-20 in your portfolio. A way to do this is to invest through the mutual fund route where even a small amount of investment can give you access to a larger number of holdings thus helping in the diversification process.
Sector exposure
There is also a situation where the exposure to a certain sector might be quite high and this also increases the element of risk in the portfolio. The investment could be in debt or in equity but if there is a high exposure to a certain area say real estate or infrastructure and then there are some tough times for the sector then this could hit you particularly hard.
A way to avoid this is to ensure that the portfolio amounts are spread out across different sectors. The situation would look rosy when things are going well as seen as was witnessed in the late nineties with information technology funds.
A couple of years later as the dot com bubble burst investors in these funds witnessed a sharp fall in value. Having an exposure to a sector fund involves higher risk but when done in the context of a portfolio and in a controlled manner it can lead to a better position on the overall returns front. Examples are Fast Moving Consumer Goods and banking funds that have done well in terms of returns.
Size of companies
There are different types of companies that are present in the economic landscape. Some of them are large in size as well as market capitalisation while others are mid size and many are quite small.
It is always better to have an exposure in your portfolio through different assets across companies of different sizes as this will balance out the risk in the portfolio. This will result in a position where the portfolio will behave differently when there are some developments that affect companies of a certain size.
Reduced volatility
When there are just a few holdings in the portfolio or a significant portion is in similar instruments then the behaviour of a large part of the portfolio could turn out to be similar. It has also been historically seen that there are various asset classes like gold and equities that do not necessarily move in the same direction at the same time.
A careful inclusion of different options can ensure that you can try and reduce the volatility. Take an example whereby there is a single holding represented by the blue line.
This will move widely depending upon the situation on a daily basis. On the other hand the movement of the red line represented by a diversified holding like a mutual fund scheme is far smaller on a daily basis. Adequate diversification acts as an attractive way for first time investors as they familiarise themselves in the investment world.
Why diversification makes sense?
Starting up
As a first time investor you require time to understand how the capital markets work and the manner in which individual securities behave. After there is familiarity with the investment you can then afford to take a higher amount of risk. Diversification is the best tool for a first time investor to make the investments in the manner that they actually want to as they can ensure that the required position suits their requirements.
Unpredictable markets
The markets are also uncertain and it is difficult to predict for a lay investor about the direction in which specific assets will move. Avoiding this difficulty is possible by diversifying across a range of asset classes and holdings so that there are balancing factors that will be at work. This will reduce the pressure to predict which investment option will be the winner in the time ahead.
Lack of expertise
As a lay investor it is difficult to spend hours in trying to analyse the possible developments in the various markets and hence diversifying not only across assets but also within assets is a good way to ensure that you do not have too many eggs in a single basket. You should look towards reducing the chances of a significant loss and this is possible by using the mutual fund route that brings along diversification.
How should I tackle this situation?
There is a long road ahead on the investment journey for first time investors like you. Starting your investments well is half the battle won and you should look to reduce risk for your investments. This will help protect against negative fallout that can even reduce your capital.
Diversification through choosing multiple asset classes which includes fixed income, equities, cash and even commodities over a period of time as you construct your portfolio would be the right way to go. Even within each of these areas efforts should be undertaken to ensure that there is some diversification that is attempted. Consider using mutual funds as an effective way of ensuring diversification in your portfolio as these are one of the best instruments that help in implantation.
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