Have you ever been advised in your stock investing journey to Never put all your eggs in one basket? If you understand why, you understand what diversification is; if not, we have you covered.
Sustainable stock market investing involves spreading your funds across disparate asset classes so you are not overly or underly exposed to any single sector or asset. If you want to learn the nitty gritty of diversification, we have covered this topic in depth in this article.
By the end of this article, you will thoroughly understand diversification in stock investing, its various forms, advantages, and disadvantages, and how to construct a robust portfolio seasoned to withstand market swings.
What is Diversification in Stock Investing?
Imagine you are going to a buffet for dinner. You are served a luxurious dinner with a variety of options to choose from. You are hungry but confused about what to eat from pizza, pasta, salad, sushi, burgers, tacos, and more. You have to choose one of the two options.
One option is to pick one type of food and eat only that. For example, you might love pizza and decide to eat only pizza for dinner. But, this way, you not only miss out on other delicious foods you could have tried, but you also regret overeating later.
Another option is to diversify your plate and eat a little of everything. For example, you might take a slice of pizza, a scoop of pasta, salad, sushi, a burger, and a taco. This way, you can enjoy a variety of flavors and textures and satisfy your appetite without overeating.
Diversification in stock investing works similarly. Instead of putting all your money into one asset class, you proactively balance it across different sectors or markets. This way, you can reap better returns and benefit from the positive changes across sectors.
Understanding Diversification in Stock Investing With Example
Imagine you put all of your money into Infosys stocks because the market is experiencing an IT boom. Assume an unexpected economic slump hits the technology sector, and you lose all of your hard-earned money all at once.
Instead, if you invest 60-70% of your funds in the IT sector and the rest, 30-40% in other sectors, Bonds, or FDs, your returns will be averaged, and you will earn higher returns than if you concentrated your investments in just one sector. Can you imagine what a disaster your returns would be if you invested all your money in banking stocks and a global financial crisis hit?
So, the best safeguard is to diversify your stock portfolio across different geographies, active or passive funds, growth or value-oriented stocks, market capitalization, industry, or sectors. However, this classification is heavily influenced by your risk tolerance, preferred time horizons, and investment objectives.
Types of Risk in Stock Investing Explained
You must accept that you cannot eliminate the risk when investing in a stock. But, you can reduce it using the tool of diversification. Broadly, your investments face two main types of risk –
- Systematic or Market Risk
Systematic risk is the risk of losing money in stock investing due to factors that affect the entire market or economy, such as wars, recessions, pandemics, natural disasters, political instability, and more.
Systematic risk is also known as market risk or non-diversifiable risk because diversifying your portfolio cannot eliminate or reduce it. Systematic risk affects all stocks in the same way, regardless of their industry, size, or performance.
For example, if a global war breaks out, all stocks will likely drop in value because investors will panic and sell their shares. Systematic risk is unpredictable and unavoidable, so investors must accept and be prepared for it.
- Unsystematic or Asset-specific Risk
Stock investing involves buying shares of companies that are traded in the stock market. However, each company or industry may face some risks that are specific to them and not to the market as a whole. These risks are called unsystematic or asset-specific risks.
They are caused by management decisions, product recalls, legal issues, or natural disasters that affect the company’s or industry’s performance and value. Investors can reduce their exposure to these risks by diversifying their portfolios across different sectors and industries.
Benefits and Drawbacks of Diversification in Stock Investing
Starting with the benefits of diversification first-
- Cuts down on your risk because if one investment underperforms, the performance of other investments that beat out can compensate for the aggregate losses.
- Diversification in stock investing may help you capitalize on opportunities and returns from various market segments and economic cycles.
- Diversification in stock investing can improve a portfolio’s risk-adjusted returns by lowering volatility and increasing return consistency.
- Diversification can also improve your peace of mind by reducing emotional stress and anxiety caused by market volatility or uncertainty.
- Diversification in stock investing can help you save time and effort in monitoring and managing your investments, as you do not need to track every single position or asset class closely.
Moving to the disadvantages of diversification in stock investing-
- Diversification may be costly and complicated to implement and maintain, requiring more research, analysis, and monitoring of multiple investments.
- Diversification can also dilute your focus and expertise, as you may be unable to keep up with changes and developments in each investment or sector.
- Diversification can expose you to new or unknown risks, such as currency, political, or regulatory risks, that may affect your returns or portfolio performance.
How to Build a Strong Well-Diversified Portfolio?
In stock investing, a well-diversified portfolio can help you meet your financial objectives, cope with market volatility, and align your values with your investments. Here are some steps to take to build a strong, well-diversified portfolio:
Step 1: Before you start building your portfolio, you need a clear idea of what you want to achieve with your investments, how long you are willing to invest, and how much risk you are comfortable taking.
Step 2: Choose the asset classes from equity, bonds, real estate, etc., that suit your risk profile, appetite, and goals.
Step 3: Once you’ve assessed which asset classes are right for you, you must decide how much money to put into each. This will be based on your investment goals, timeline, and your capacity for risk.
Step 4: The final step in building a well-diversified portfolio is to monitor and rebalance it periodically. Monitoring your portfolio involves tracking the performance, risk, and value of your investments, as well as the changes in the market conditions and your circumstances.
Rebalancing your portfolio involves adjusting your asset allocation and stock investing products to maintain your desired risk-return profile and achieve your financial goals.
Diversification through sustainable investing in the Indian stock market: Explained
Sustainable investing is gaining popularity among investors who want to align their values with their investments and contribute to a better world. It is the practice of stock investing in companies or funds that promote environmental, social, and governance (ESG) practices in their business operations and strategies.
Sustainable investing aims to generate positive social and environmental impact and financial returns.
If you want to incorporate sustainable investing in the stock market in your portfolio, you can follow these steps:
- Identify your ESG preferences and goals, such as climate change, human rights, gender equality, or corporate governance
- Choose the ESG approach that suits you, such as negative screening, positive screening, thematic investing, or impact investing
- Select the ESG products that match your ESG approach, such as ESG funds, ESG indices, or ESG stocks
Monitor, evaluate, and rebalance your ESG portfolio periodically to ensure it maintains your desired risk-return profile and achieves your financial goals.
To sum up, diversification is a vital technique for stock investing that can help you reduce your risk and increase your returns. Investing in different asset classes, industries, sectors, and geographies allows you to create a balanced portfolio that suits your profile and goals.
You can also incorporate sustainable investing in the stock market as a diversification strategy to positively impact the world. Diversification requires careful planning, selection, monitoring, and rebalancing of your investments. Following the steps discussed in this article, you can build a strong, diversified portfolio to help you achieve your financial dreams.
What are some common mistakes to avoid when diversifying your portfolio?
Some common mistakes to avoid when diversifying your portfolio include over-diversifying or under-diversifying your portfolio and diversifying without a clear strategy or objective. Often our diversification is based on emotions or biases, without considering our risk tolerance or time horizon, without researching or analyzing our investments, and without monitoring or rebalancing our portfolio.
How to measure the effectiveness of your diversification strategy in stock investing?
You can measure your portfolio’s volatility or consistency using various metrics and tools such as risk-adjusted return, Sharpe ratio, correlation coefficient, beta coefficient, standard deviation, variance, and R-squared.
Using these tools and metrics requires expertise, highlighting financial advisors’ importance in maintaining optimal diversification.
How to choose the investment products for a diversified portfolio?
You can choose from various investment products, such as direct and managed products. Direct investments such as Stock investing or bonds give you more control and flexibility over your portfolio, but they also require more research, analysis, monitoring, and transaction costs.
Managed products such as ETFs or Mutual funds offer you more convenience and diversification, but they also charge fees and expenses that can reduce your returns.