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Financial Literacy

Why Should You Diversify Your Investments?

In the previous sections, we saw the various products that are available to us for investment. It is essential for us 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. 

 

Harry Markowitz, an American Economist and Nobel Laureate, puts the importance of diversification this way, “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, and so you lose all ₹1000. Now, if you would’ve put some of this money into a different investment, the burden of your loss would have been lesser. This is how diversification reduces risk.

 

Beware of These Behaviour Patterns While Investing!

 

There are two basic behavior patterns that you should stay away from, to be the best investor that you can be 

 

1. Expert Opinions 

Sometimes, people have a tendency to invest by listening to -

  • The “so-called” experts on television; or 
  • Friends and relatives.

It may happen that the stock which they are suggesting may be suitable for him/her but not for others since time plays a key role in investing.

 

Saying a stock which looks a very poor investment in the short run could be a very good investment for the long term.

 

Hence, the right path would be to either -

  • Put your money in an expert’s hand; or 
  • Start with your own research.

2. Herd Mentality

If you have purchased a stock simply because you’ve seen a lot of your friends or relatives purchase it as well, you’ve fallen into the trap of herd mentality.

 

Basically, “following the herd” means -

  • You don’t make a calculated decision; or 
  • You simply do what the others are doing.

When it comes to investing, it is always better to make your own informed decisions as per your financial goals, or consult an adviser before taking the dive.

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Units 7/11