Why is investment portfoilo diversification important?

Investment Portfolio Diversification Meaning

Investment portfolio diversification is a finance term used frequently by investors and businesses. The portfolio is a combination of financial investments. This can either be uniform or diverse. It means putting all investments in one area, category or asset class would create a uniform portfolio which translates into a high-risk investment. On the other hand, a diverse portfolio consists of investments made in various groups. Portfolio diversification can be of two types:

  1. Between asset types
  2. Within asset types

Diversification between Asset Types:

Diversification among asset classes means putting your money in several different asset types. The assets can be classified into two types:

  • Growth assets
  • Defensive assets

The growth assets encompass higher Risk and higher returns. These include stocks and real estate. At the same time, the defensive investments are low-risk and low-return. These consist of bonds, gold, cash, fixed interest on bank certificates, mutual funds etc.

Diversification within Asset Types:

Further categories of each asset should also be considered while investing. For instance, bonds can either be,

  • Short-term or long-term
  • Corporate or government
  • High quality or Low quality

Similarly, stocks can be diversified based on,

  • Type of industry like few stocks in the transportation industry and another few in the textile industry.
  • Size of the firm like small-cap, medium-cap, and large-cap stocks.
  • Variation based on a region like Domestic and Foreign stocks. For instance, a resident of the USA invests in the majority of USA stocks but also buys a few stocks in China.

Importance and Benefits of investment portfolio diversification

The purpose of portfolio diversification is to spread the Risk over various asset categories in order to create maximum opportunities for profit growth.

Spreading Investments = Spreading Risk

A diversified portfolio reduces ‘unsystematic risk’ that affects a specific company and not ‘systematic risk’ that affects all market companies. Diversification of portfolio does not guarantee greater returns, but it surely provides security against huge loss as the investor is not putting all eggs in one basket. According to the finance experts, all asset classes don’t respond identically to a market event. For instance, a bond and stock are totally different financial instruments. Stocks being growth assets involve greater Risk and a greater return. Under unfortunate circumstances, like a pandemic, the stock market is negatively impacted, which results in a loss for the investor. In contrast, bonds, defensive assets, provide small yet stable returns remaining unaffected by such circumstances. In such a scenario, putting money in both bonds and stocks would prevent the investor from taking a bat. 

Greater Opportunities to Grow Profits

A second advantage provided by a diversified portfolio is seizing all opportunities for obtaining returns from a number of different asset classes, industry types, firm sizes, location benefits, duration of returns etc. Suppose person A invests all his money in the airline sector and person B invests the same amount in the airline, railway, apparel, footwear, retail, and real estate sectors. Although the airline industry showed increasing gains for the past few decades, the sudden strike of the covid-19 pandemic imposed a ban on flights, resulting in the sector’s downfall. Hence, person A’s total investment went down in flames. However, person B only lost a portion of his investment from each asset class given his portfolio diversification. 

Therefore, investors should definitely diversify their portfolios as broadening the avenues of investment effectively balances their Risk and return.

Conclusion on investment portfolio diversification

Investment diversification is an important factor in managing finance. The investment portfolio needs to be diversified in terms of sector, location, products, services, locations, and many other aspects.

However, first, you need to decide if want to set a growth intensive portfolio strategy or need to defend somewhere. If you opt for the growth, there is a need to presume a risky portfolio. On the other hand, low-risk securities can be presumed if you intend to remain defensive.  

Conitnue reading, Improtance of cash flow analysis

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