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Financial Literacy

Why Should You Diversify Your Investments?

In the previous sections, we saw the steps to create a balanced portfolio and the various products available for investment. We need to split the funds into different products instead of putting all our money in one place. As Warren Buffett said, “ Do not put all your eggs in one basket.”

This process of splitting our funds is known as diversification

Diversification means spreading your investments across different types of assets, like stocks, bonds, and real estate, as well as different industries and places around the world. This helps lower the risk because if one investment doesn't do well, others might do better, balancing things out. The goal is to have a mix of investments that aren't too similar to each other.

Harry Markowitz, an American Economist and Nobel Laureate, explains the importance of diversification: “Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero.” 

 How does this work?

Suppose you have ₹1000 in savings, which you decide to invest in the shares of a company. Two months later, the company goes bankrupt, and it cannot afford to pay you back anymore, so you lose all ₹1000. Now, if you had put some of this money into a different investment, the burden of your loss would have been lesser. This is how diversification reduces risk.

Diversification can be around-

  • Sectors and Industries

  • Companies 

  • Asset Classes 

  • Time Frames

Benefits of Diversification

  • Protecting Wealth: Diversification helps older investors and retirees safeguard their money, especially when they rely on their investments for income.

  • Boosting Returns: Diversification aims to increase returns while managing risks. It's like getting more bang for your buck, considering the risks involved.

  • Creating Opportunities: Diversification opens doors to new possibilities. For instance, if you invest in different sectors, you might benefit from unexpected successes, like a streaming company making a big content partnership.

  • Adding Fun to Investing: Diversifying can make investing more exciting. Instead of focusing on just one area, it encourages exploring various industries and companies, which can be both stimulating and rewarding.

There are a few disadvantages as well

Not everyone is knowledgeable enough to make a diversified portfolio. It might reduce the risk but, at the same time, will have the possibility to reduce the expected returns. Diversification helps in reducing some losses, but we cannot define diversification as a shield for all kinds of losses.

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Units 7/11