Investment Portfolio Diversification: Rationale & Mistakes To Avoid
To relate with investment portfolio diversification, we may draw the example of a fruit seller. Usually, a fruit seller is selling variety of fruits. The reasons are quite simple. Consumer preferences vary. If a natural calamity like a hurricane wipes out the orange groves of a particular location, he can still earn his living by selling bananas or apples which he procures from other locations. It would also make sense to tie up with different suppliers of oranges from different locations. If one supplier had unforeseen problems, he can reach out to other suppliers. Basically the fruit seller has diversified his business in the following ways:
- Selling variety of fruits
- Dealing with different suppliers of fruits
Similarly, as you are investing for your financial goals, it is wise to maintain a diversified portfolio.
Purpose of investment portfolio diversification
All investments involve some degree of risk. In simple terms, here risk is the possibility of losing money. The justification behind investment portfolio diversification is risk management. Investment portfolio diversification is the practice of spreading your investments across asset classes so that your exposures to assets are optimum. Diversified investments won’t move in the same direction at the same time. Practically, it is not feasible to predict which asset class or which sector will outperform or under-perform benchmarks and when that may happen.
Factors to consider while planning for portfolio diversification
Despite diversifying the investment portfolio, many investors are missing out on vital components of investment strategies. This may make their holdings more concentrated and complicated. Therefore, they are exposed to greater risk than they realize.
People generally have the perception that lower the age of an investor, higher can be the risk element in the investment portfolio and vice versa. However, there are varying parameters to be assessed while designing investment portfolio.
While practicing as Financial Advisor in Kolkata, risk profiling remains the cornerstone of our financial planning and investment advisory services. Risk profile of an investor influences portfolio diversification strategy. It may happen that a person has the capacity to take risks in investing but he/she is unwilling to bear too much risk. Again, there can be a person who is willing to take huge investment risks but he/she doesn’t have the proper capacity to tolerate the risks. Therefore, detailed risk profiling process of an investor enables us to perceive how much risk element may be appropriate for the particular investment portfolio.
Financial situation of a person contributes towards developing a suitable portfolio diversification strategy. At thirties, your personal preferences in investing will be vastly different from the choices you make in your forties. As Certified Financial Planner in Kolkata, we primarily focus in understanding the investor’s financial situation. Nature of income plays a role in determining suitable portfolio diversification strategy. We need to recognize how many family members are financially (totally/partially) depending upon his/her income. Also, we need to appreciate his/her financial commitments. Each aspect has its own relevance.
The portfolio diversification strategy must be in sync with your financial goals. Nature of financial goal and the time horizon of such goal govern the investment strategies along with above stated parameters. Your financial goal may change. Consequentially, your investments must be realigned as per your overhauled financial goal. As Financial Consultant in Kolkata, we follow certain processes to comprehend both quantitative as well as qualitative inputs from our individual and family clients.
It is implied that financial markets can be volatile and unpredictable. Global as well as domestic macroeconomic factors determine financial market movements. Each sector goes through business cycles.
You need to understand how your investments will be effected as economic preconditions evolve and change.
Therefore, investment strategies are to be tailor-made based on investor’s personal factors along with macroeconomic aspects.
Mistakes to avoid
When it comes to portfolio diversification, investors are taught that they should not put all their eggs in one basket. Sometimes, it is easier said than done. The problem with diversification is that many investors don’t do it properly. In our experience as SEBI Registered Investment Advisor in Kolkata, most investors aren’t aware of how to diversify investments in an optimum way. They make some costly mistakes while trying to craft a well-diversified portfolio.
In present day, behavioral finances play the important role for the investment decision making. There are various options or choices available for the investors in the market while taking investment decisions. An investor may display many behavioral biases that may have an adverse impact on investment decisions.
Investment decisions should not lead to battles between your head and heart. For some people it can be difficult to ignore emotional pulls, like a gut feeling to buy the hot stock of the month or to sell when the market is experiencing volatility. Emotions are hindrances in your journey towards financial well-being.
The volume of market and economic information is increasing exponentially. At times, the so called information may be a mere market noise. What investors really need is a process that helps to reduce the noise to a level that keeps them safe from making irrational decisions.
Diversification of investment portfolio should not be done randomly
Absence of proper guidance and lack of financial awareness is damaging. Even if you are investing, you may not know whether you’ll be reaching your target within the required timeline. Random attempt of portfolio diversification can lead to complications. The investment portfolio must be simple and in sync with your exact needs. It should be such that your potential family members can execute the same in your absence or in case of your inability to do so due to any eventuality. You need to make sure that while diversifying your investments, you are not doing too much. Over-diversification is pointless and counterproductive.
