How to Build a Diversified Portfolio

In this article, we will discuss

• What is Portfolio Diversification?
• An Example of Portfolio Diversification
• How to Build a Diversified Portfolio?
• Common Pitfalls to Avoid When Building a Diversified Portfolio
• Conclusion

A diversified portfolio is one of the foundational pillars for long-term wealth creation. Attempting to achieve financial goals without a well-diversified investment portfolio can be complex, challenging, and risky.

While the benefits of diversification cannot be disputed, how many of us know how to build the right portfolio of assets? This article aims to address this particular issue. Read on to learn about portfolio diversification, its importance, and how you can effectively build a diversified investment portfolio that satisfies your investment goals and remains protected from adverse market movements.

What is Portfolio Diversification?

Portfolio diversification is a strategy that investors use to manage risk. It involves investing in various kinds of assets that belong to different categories, sectors, and geographies. The primary objective of such a strategy is to minimise the impact of unexpected market movements on the investment portfolio.

Diversification operates under the assumption that different asset classes will react differently to the same event. Therefore, if one investment underperforms, the other investments may perform better, which can ultimately offset the losses.

An Example of Portfolio Diversification

To better understand the concept of portfolio diversification, let us consider a hypothetical example.

Assume you have Rs. 5 lakh as investment capital. You believe that the future growth potential of Company X is good and that it will deliver good returns in the long run. Therefore, you invest your entire capital of Rs. 5 lakh in Company X. However, due to a corporate governance issue, the stock of Company X fell by about 20%. Since you have invested your entire capital in just this stock alone, your loss would also be 20%, amounting to Rs. 1 lakh (Rs. 5 lakh x 20%).

Let us now look at what happens when you diversify your investments. Assume you spread your Rs. 5 lakh investment capital across multiple assets instead of investing it entirely in Company X. You decide to allocate your capital to the below-mentioned assets in the following proportion:

• Rs. 1 lakh (20%) in Company X
• Rs. 1 lakh (20%) in a broad-market index fund, such as a Nifty 50 index fund
• Rs. 1 lakh (20%) in government bonds
• Rs. 75,000 (15%) in real estate investment trusts (REITs)
• Rs. 75,000 (15%) in infrastructure investment trusts (InvITs)
• Rs. 50,000 (10%) in gold

As we have already seen, the stock price of Company X fell by 20%. All other assets, however, have gained in value by an average of 4%. The loss in this case would amount to Rs. 4,000 [(Rs. 4 lakh x 4%) - (Rs. 1 lakh x 20%)].

Thanks to a diversified investment portfolio, you were able to significantly reduce the negative impact on your capital by reducing the loss from Rs. 1 lakh to just Rs. 4,000.

How to Build a Diversified Portfolio?

Now that you have seen how a diversified portfolio can be beneficial to you as an investor, let us now look at how you can construct one.

Contrary to popular opinion, building a diversified portfolio is not as easy as it may seem. In fact, it requires careful planning and consideration of various factors. Here is a step-by-step guide that can help you create a well-diversified investment portfolio.

• Step 1: Determine Your Investment Goals and Risk Tolerance

Your financial goals, risk tolerance and investment horizon are the three major factors that determine the kind of assets you need to include in your investment portfolio. Therefore, before you dive into the specifics of investments, you must first define your financial goals and assess your risk tolerance.

If you are unsure of your goals and risk tolerance, answering certain questions can bring you some clarity. For instance, are you investing for retirement, a major purchase, or simply wealth accumulation? How much risk are you comfortable taking? Your answers to these questions will guide your asset allocation strategy.

• Step 2: Understand Different Asset Classes

Once you have identified your goals, risk tolerance, and investment horizon, the next step is to understand the various asset classes you can invest in. The Indian financial markets are replete with a plethora of attractive investment options, each with its own advantages and risks. Only by understanding the various asset classes can you pick the ones that are right for you. Here are some of the most popular financial assets you can consider investing in:

• Equity Stocks

Equity stocks represent ownership in companies. By investing in stocks, you get the potential for capital appreciation and dividends.

• Bonds

Bonds are debt instruments issued by companies and governments. Bonds offer regular interest payments and the return of principal at maturity. The interest rate on bonds varies depending on the issuer, the credit ratings, and whether they are secured or unsecured. They are not as volatile as stocks

• Real Estate

Real estate offers the potential for capital appreciation as well as regular income by way of rent. You can invest in real estate by purchasing properties or real estate investment trusts (REITs).

• Cash and Cash Equivalents

Cash and cash equivalents include savings accounts, fixed deposits, recurring deposits, money market funds, and short-term government securities like Treasury bills (T-bills). These investments have high liquidity and can quickly be converted to cash.

• Gold

Gold has long been considered an attractive long-term investment option due to its ability to consistently beat inflation. You can invest in the precious metal by purchasing physical gold, gold exchange-traded funds (ETFs), or sovereign gold bonds (SGBs).

• Alternative Investments

Apart from the traditional investments mentioned above, there are also a few alternative investment options. These include cryptocurrencies, private equity, hedge funds, and peer-to-peer lending. Most alternative investments may not be well-regulated and usually have high risks.

• Step 3: Allocate Assets Based on Your Goals and Risk Tolerance

Proper asset allocation is by far the most crucial aspect of a diversified portfolio. When allocating assets, remember to factor in your financial goals, risk tolerance, and investment horizon.

Most investors usually go for a 60:40 portfolio allocation ratio, which they consider to be a balanced approach to creating wealth. In this case, about 60% of the assets are invested in stocks, with the remaining 40% in bonds.

Aggressive investors with a high tolerance for risk tend to use an 80:20 ratio, where 80% of their capital is invested in stocks and 20% in bonds. On the other hand, conservative investors use a 40:60 ratio, where 40% is directed towards stocks and 60% towards bonds.

If you are a beginner investor, you can start with the 60:40 approach and slowly diversify your investments once you gain enough experience. Also, remember to explore traditional investments other than stocks and bonds, such as gold, bank deposits and government savings schemes. Including them in your investment portfolio can bring about stability and may even protect you from the negative impact of adverse market movements.

• Step 4: Diversify Within Asset Classes

Diversification is not just about including different asset classes in your portfolio. To create the best investment portfolio, you must diversify within each asset class you choose.

For instance, when investing in equities, consider including companies across large-cap, mid-cap, and small-cap segments in your stock portfolio. Also, you can invest across different sectors and include international stocks from developed and emerging markets. This way, you can not only effectively reduce portfolio volatility and risk but also capitalise on the various opportunities these stocks offer.

The same principle could be applied to other asset classes, like bonds, as well. For example, including government and corporate bonds with different credit ratings and maturities can help you create a good investment portfolio that can perform well irrespective of the prevailing market conditions.

• Step 5: Consider Low-Cost Index Funds and ETFs

When building a diversified stock portfolio, most investors tend to focus on investing in individual stocks or mutual funds. While they may offer better capital appreciation, they are also susceptible to market volatility. Furthermore, there is always the risk of the stock or mutual fund underperforming compared to its benchmark index.

One of the many ways to deal with such shortcomings is by including low-cost index funds. Index funds are a type of mutual fund that aims to replicate the performance of a particular market index, such as the Nifty 50, Nifty 100 or Sensex. These funds are based on the principle that indices generally tend to perform better than most mutual funds, especially in the long run.

A major advantage of index funds is that they usually have more diversified stock portfolios compared to regular mutual funds. This gives them the ability to withstand short-term market fluctuations better. Also, index funds are passively managed, meaning that the fund managers do not make any changes to the fund’s portfolio unless there is a change in the index. Since there is no active management involved, the expense ratios of these funds tend to be very low, which could potentially lead to higher overall returns.

The same is the case with exchange-traded funds (ETFs) as well. They are again a type of passively managed mutual fund that tracks a particular market index. However, unlike regular funds, the units of an ETF are listed on the stock exchanges and traded between investors like stocks. The expense ratios of ETFs are also very low.

• Step 6: Rebalance Regularly

Building a diversified portfolio is not only about selecting the right asset classes. It is also about ensuring that they are always aligned with your target. Over time, some investments in your portfolio may outperform others. This could cause your asset allocation to change and drift away from your goal. Here is where rebalancing your investment portfolio regularly can help.

Rebalancing involves buying or selling assets in your portfolios with the aim of returning them to their original target asset allocation mix. Here is an example of how rebalancing works.

Assume you have Rs. 1 lakh as investible capital and that the ideal asset allocation mix for satisfying your goals is 50% in stocks, 30% in bonds, and 20% in gold. You proceed to invest in these three assets in the recommended proportion.

About a year later, you see that your stock portfolio has grown significantly compared to your bond portfolio and gold. This has skewed your asset allocation mix heavily in favour of stocks. Currently, 65% of your portfolio is made up of stocks, with bonds and gold representing 20% and 15%, respectively.

To bring it back to the original asset mix of 50:30:20, you decide to rebalance your portfolio. Now, there are two ways to rebalance your assets. You can either sell some of your stock holdings to reduce their proportion in your investment portfolio or you can increase your bond and gold investments instead.

Common Pitfalls to Avoid When Building a Diversified Portfolio

Now that you are aware of how to construct a diversified portfolio, here are some of the common pitfalls that you must stay away from.

• Over-diversification

Over-diversification is one of the most common pitfalls that you are likely to face when you diversify your investments. In a bid to reduce risk, you may end up including too many investments in your portfolio. Such over-diversification could potentially lead to lower returns and make managing your portfolio a lot more challenging.

• Favouritism

As humans, we are susceptible to many emotional biases, with favouritism being one of them. When choosing asset classes, you may find yourself favouring some of them over others. For instance, you could favour stocks over bonds, or vice versa. Letting such biases creep into the asset selection process could lead to suboptimal decision-making. Therefore, as an investor, you must always ensure that you are objective during the asset selection process.

• Not Accounting for Costs

When diversifying your portfolio, you must always consider the costs associated with your investments. High fees could potentially lower the returns over time. And so, it is advisable to be mindful of the various expenses, especially when investing in actively managed funds.

Conclusion

Building a diversified portfolio is important to being successful at investing. By spreading investments across various asset classes, you can effectively manage risk while simultaneously ensuring that the returns are on par with your expectations.

That said, it is important to remember that diversification doesn't guarantee returns or fully protect you against losses in a declining market. It is merely a time-tested risk management strategy that can lessen the negative impact of adverse market movements on your portfolio.

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