With stocks and other assets booming for much of the past couple years, investors may find themselves with one or two securities that account for a large portion of their total portfolios. Now may be a good time to think about ways to diversify your portfolio so that your fortunes aren’t tied to just a few investments.
What is diversification?
Diversification is a way to manage risk in your portfolio by investing in a variety of asset classes and in different investments within asset classes.
Diversification is a key part of any investment plan and is ultimately an acknowledgement that the future is uncertain and no one knows exactly what’s going to happen. If you knew the future, there’d be no need to diversify your investments. But by diversifying your portfolio, you’ll be able to smooth out the inevitable peaks and valleys of investing, making it more likely that you’ll stick to your investment plan and you may even earn higher returns.
Ways to Help Diversify Your Portfolio
Diversification is not a new concept. With the luxury of hindsight, we can sit back and critique the gyrations and reactions of the markets as they began to stumble during the dotcom crash, the Great Recession, and again during the COVID-19 recession.
We should remember that investing is an art form, not a knee-jerk reaction, so the time to practice disciplined investing with a diversified portfolio is before diversification becomes a necessity. By the time an average investor “reacts” to the market, 80% of the damage is already done. Here, more than most places, a good offense is your best defense, and a well-diversified portfolio combined with an investment horizon over five years can weather most storms.
Learn why diversification is a must
A diversified portfolio helps your overall investments to absorb the shocks of any financial disruption, providing the best balance for your saving plan. But diversification is not limited to just the type of investment or classes of securities; it also extends within each class of security.
Invest in different industries, interest plans, and tenures. For instance, do not put all your investments in the pharmaceuticals sector, even if it among the best-performing sectors amid the Covid-19 pandemic. Diversify in other sectors that are picking up, such as education technology or information technology.
Broadly speaking, there are two basic types of investment – stocks and bonds. While stocks are seen as high-risk with high returns, bonds are usually more stable with lower returns. To minimise your risk exposure, you should divide your money between these two options. The trick lies in balancing the two, in finding equilibrium between risk and surety.
Asset distribution is typically based on age and lifestyle. At a younger age, you can take a risk on your portfolio, opting for stocks that offer high returns.
A good way of allocation is to subtract your age from 100 – this should be the percentage of stocks in your portfolio. For example, a 30-year-old could keep 70% in stocks with 30% in bonds. On the other hand, a 60-year-old should reduce risk exposure, hence, the stock to bond allocation should be 40:60. However, you may have to factor in your family finances when taking these decisions.
If you share a high proportion of the family expenses, you should be more cautious about your investments. It would limit the amount of capital you have at your disposal, and therefore, you may want to play safe with a higher tilt towards bonds.
Assess the qualitative risks of the stock before investing
You can minimise the unpredictability of stock transactions by applying qualitative risk analysis before buying or selling a stock. A qualitative risk analysis assigns a pre-defined rating to score a project’s success. To apply the same principle, you have to evaluate the stock through specific parameters that indicate its stability or the potential to do well.
These parameters will include a robust business model, integrity of senior management, corporate governance, brand value, compliance with regulations, effective risk management practices, and the dependability of its product or services, coupled with its competitive advantage.
Invest in money market securities for cash
Money markets instruments include certificates of deposit (CDs), commercial papers (CPs), and treasury bills (T-bills). The biggest advantage of these securities is the ease of liquidation. The lower risk also makes it a safe investment.
Of all market securities, T-bills are the closest to risk-free securities that can be bought individually. Issued by the banking regulator the Reserve Bank of India, these government securities or g-secs are backed by the central government. They provide an ideal option for short-term investments that are guaranteed to be secure.
While g-secs are known for safety, they are not known for high returns. What makes a g-sec secure is its insulation from market fluctuations, but this also removes the likelihood of making a substantial gain as in the case of stocks. You can invest in g-secs if you want to park your money in a safe place for the short term. You can also use it as a part of your portfolio to offset against other ‘riskier’ investments, such as high-value, high-risk stocks.
Invest in bonds with systematic cash flows
Mutual funds are seen as a reliable and stable investing option. But within mutual funds there are numerous options for investment, interest accumulation, and redemption.
If you want to access your money even as it is locked in a savings plan, consider investing in mutual funds with systematic cash flow, also called a systematic withdrawal plan (SWP). Under these types of investment, you can withdraw a fixed amount monthly or quarterly. You can customise withdrawal, opting for a fixed amount or against profits.
A similar alternative is systematic transfer plan or STP where you can transfer a fixed amount between different mutual funds. STP helps to maintain a balance in your portfolio. In either case, the objective is to provide access to investments at fixed intervals.
Follow a buy-hold strategy
An investment plan is essentially your long-term saving plan. So, you have to start thinking long-term and avoid knee-jerk reactions. Think buy-hold instead of a constant trading strategy. It means keeping a relatively stable portfolio over time, irrespective of market fluctuations.
Unlike constant trading, it’s a more passive approach where you allow your investments to grow. That said, don’t be afraid to curtail holdings that have appreciated too quickly, or take up more of your investment portfolio than is required or prudent.
Understand factors that impact the financial markets
Before investing in financial markets, you need to first understand the factors that influence its movement. Financial markets include stock exchanges, foreign exchanges, bond markets, money markets, and the interbank markets. These are essentially a marketplace for financial instruments and, like any other market, they function on demand and supply.
Like any other market, there are also external factors like interest rates and inflation that influence its dynamics. The other major influence is the central bank, the Reserve Bank of India and its monetary policies.
Learn about global markets
Global markets have the potential for high returns in a short time. These markets are usually characterised by an extremely fast-moving dynamic where an investor must also deal with multiple monetary regulations. As a young investor, it can take some time to learn its functioning, understand trends and fluctuations, and what drives these shifts. But it can be highly rewarding, especially when the Indian market is experiencing a sustained downturn.
You can start with an exchange-traded fund (ETF) or a mutual fund with a low-cost structure and ample liquidity. It will allow you to invest safely with a small amount of capital, giving you the perfect opportunity to observe and understand how the global market works.
Rebalance your portfolio periodically
Balance is important in life and in investment. It is important to periodically check your investment portfolio to check the balance of various assets. This review should be based on your goals and major life milestones along with evaluation of where you started from and how far you have come.
A financial advisor can help you review your investments vis-à-vis your lifestyle, while advising you on other available options. This exercise also makes you more disciplined about your investment, while keeping you aware of its yearly growth. These two factors will eventually help you make more informed decisions, while developing a finer insight into investments in the future.
Try a disciplined investment scheme like a systematic investment plan (SIP)
If you have a small amount that you want to invest over a given time rather than investing a huge amount at one time, a SIP is a good option. Under this method, you can invest a fixed amount in mutual funds at fixed intervals. It is ideal for those who do not have access to a large amount, but can afford to invest only a small sum each month.
You can start a SIP with as little as INR 500. SIPs are also ideal for young investors because they help you inculcate discipline in your investment strategy. The investment amount gets deducted directly from your bank account, getting you used to the idea of setting aside a fixed amount regularly, for your future. Since it is based on compound interest with low overall risk, it also allows your investment to stay safe.
But remember, diversification is again the key. Invest in different types of industries and interest formats.
Invest in life insurance
Few young adults in India think of investing in life insurance. It can be difficult to imagine death, as a youth, especially if you are not married or have other dependents. But the age-old advice of treating life insurance as an essential investment avenue holds true, especially when you are young owing to the low premium rates your insurance company is likely to offer you at a younger age.
Life insurance companies decide premiums according to age, and the younger you are, the lower your premiums. Life insurance may not benefit you now, but it will safeguard your loved ones when you are not there.
You can also earn on your life insurance by investing in unit linked insurance plans (ULIPs), which combine life insurance with market-linked investments. A portion of the investment amount goes towards the insurance premium, while the rest is invested in the market. This is a long-term plan, and an early start can help you invest for future milestones. Remember to compare different ULIPs before investing.
Be aware of your financial biases
When planning your investments, you should be aware of the prejudices and ideas that are likely to influence your decisions. We are often influenced by external factors, particularly risk aptitude, family attitude, luck, and cultural beliefs.
The risk aptitude refers to the level of risk you will be willing to take, which often depends on the family background and cultural attitudes. Young adults from well-off families are more likely to go for high-risk, high-return investments. On the other hand, those from a modest background are more likely to invest in safe portfolios. Family attitudes also influence our willingness to trust the ‘luck’ factor.
Another unique characteristic is the cultural influence that decides our investments. For instance, some communities prefer investing in gold, while some prefer investing in land.
You can be more confident in bonds or fixed-income investments than in stocks. When you make a fixed-income investment, the amount you’re due to make and the period in which you’ll make it will be set out in a contract, and your earnings be paid out to you in the form of regular interest payments. As such, bonds are considered to be less high-risk than stocks are.
They are, however, often less rewarding, with the return on investment significantly lower than what you might expect as a shareholder.
For those who prefer to take on more of a back seat in investing, managed funds are a good option. Managed by a fund manager who buys and sells shares for you, your money will be pooled with other investors.
The fund might focus on one particular asset class, or it could be more diverse. Either way, each investor will own a set number of units in the fund, and any earnings will be divided between the investors based on how many units they own.
Property investments are less liquid than the above investment options and are considered moderate to high risk. It doesn’t help that, at the moment, house prices are sky-high, which makes getting on the property ladder all the more difficult. But, the property offers a good return on investment, particularly if you hold onto it for an extended period.
Annuities are a sort of guaranteed retirement income that ensures you get your earnings irrespective of how the market behaves. Usually purchased using some or all of your pension, the amount you put in will determine how much you get out. And you can also choose whether you want to receive your payments over several years or for the rest of your life.
The most recent (and futuristic) investment option to arrive on the scene is cryptocurrency. A cryptocurrency is a digital currency used to pay for goods and services. There are plenty of cryptocurrencies, including Bitcoin, Litecoin, and Ether.
Taxwise, investing in cryptocurrencies is quite complicated — however, more recently, it has become easier with a lot of the tax being automated via read-only API keys from crypto exchanges.
The interest of this unregulated currency is most often used for trading for profit. Just be aware that investing in crypto is risky, and be sure to undergo due diligence and take proper risk management.
The purpose of investing is to give your money the opportunity to grow and help you work towards your other life goals. The earlier you start, the more time you can give your investments to reach their potential.
More importantly, it helps you get used to financial discipline, the habit of saving, and the understanding of investment instruments. An early start gives you financial freedom and stability to pursue other interests and improve your quality of life.