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We discussed risk and return earlier. But how are risk and return related?
Well, risk and return are positively correlated, as in when one takes a higher risk, the return potential is also higher and vice versa. However, it doesn’t mean one has to take excessive risk to earn high returns.
Every investor should assess their risk tolerance and invest accordingly.
Portfolio diversification is the technique of reducing the risk of the overall portfolio by allocating money into different kinds of financial instruments, industries, countries, etc. The aim is to maximize returns by mitigating risk.
Diversification does not eliminate risk but instead aims to minimize it.
Let us understand this through an example. Suppose on 1st January 2020, you wanted to invest ₹1,00,000. You are new to the world of investments and always wanted to participate in the stock market. You invest half of your money in ICICI Bank Ltd. and half in ITC Ltd. On 1st January 2020, ICICI Bank closed at ₹536.75 and ITC closed at ₹ 238.15. For ease of calculation, let us assume you bought ICICI Bank at ₹535 and ITC at ₹235.
So, your investment would look something like this:
When the Covid-19 pandemic hit the world, global markets crashed, and the Indian Markets followed suit. On 23rd March 2020, the markets went down significantly. ICICI Bank closed at ₹284 while ITC closed at ₹ 154.3. So, the values of your investment in ICICI would have fallen to ₹ 26,412 and ITC would have fallen to ₹ 32,711.6.
In other words, the value of your ₹ 1,00,000 would have become ₹ 59, 123.6.
Instead, if you had split the ₹ 100,000 four ways and invested ₹ 25,000 each in ICICI Ltd shares, ITC Ltd shares, HDFC Gold ETF, and Axis Bluechip fund, what would have happened?
The closing NAV of HDFC Gold ETF on 1st January 2020 was ₹ 3521.90 and Axis Bluechip Fund was ₹35.76. For ease of calculation, let us assume you bought HDFC Gold ETF for ₹ 3,500 and Axis Bluechip Fund for ₹ 35.50.
On January 1, 2020, your investment would have looked something like this:
So, on 23rd March 2020, when markets fell sharply, your portfolio would have looked something like this:
As you can see, effectively, you would have lost a much lesser amount by diversifying your portfolio.
A thing to note here is the fact that the portfolio has incurred losses in the second scenario as well, although the amount of the loss is much lesser. This brings out the fact that the purpose of diversification is to reduce risk, not eliminate it.
Purpose of portfolio diversification
As mentioned above, the primary objective of portfolio diversification is minimizing risk. When we talk about risk, we talk about two different types of risk – systematic and unsystematic risk.
Total Risk = Systematic + Unsystematic Risks
Systematic risk is the inherent risk of the entire market and reflects the impacts of several factors in the market – economic, geo-political, financial, etc. Systematic risk is generally unpredictable and is often considered as unavoidable.
Unsystematic risk, on the other hand, is a company-specific risk or the risk associated with a particular investment in a portfolio. This is the risk that can be avoided through diversification.
How many financial instruments should you include?
This is a frequently asked question with regards to portfolio management. And the answer is ‘no one knows for sure’. Naturally, having five shares is better than one. But there is no golden answer. It entirely depends on your risk appetite and your knowledge of different financial markets.
When it comes to a share portfolio, some experts opine that having 15-20 stocks is a good starting point. However, honestly speaking, this will vary from one person to another.