Concept of Diversification of Portfolio
Diversification of Portfolio: Have you heard of the famous saying; “you should not put all your eggs in one basket”? The saying holds true because putting all eggs in one basket amounts to high risk of damage and you might lose all your eggs. Same is the case with your investments. You should not invest all your money in one type of investment or in one single stock. Reason being, one single bad news in that particular stock or industry can bring down the price of the stock. You might incur a huge loss if the particular investment does not do well. Therefore, you must consider diversification of your portfolio.
Meaning of Diversification of Portfolio
Diversification of a portfolio is a practice of spreading your investments to minimize your risk exposure. It is one of the keys to successful investing.
It is not always that all the stocks will perform well. Some types of stocks will do well at certain times, while others won’t. But if your portfolio is diversified, meaning you have a variety of stocks, you are saved. It is likely that some of your stocks will fetch you profits if others are fetching losses. Moreover, diversification of portfolio helps to reduce the effect of stock market volatility.
Benefits of Diversification of Portfolio
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Reduces Risk
Diversification of portfolio helps in reducing risk. By adding stocks from various sectors in the portfolio, the chances of incurring losses in all the sectors at the same time are very less. As we are aware that elimination of complete risk in any portfolio is not possible. However, the management of risk is very much possible. Therefore, diversification helps in managing the risk of a portfolio. To put in another way, portfolio diversification helps in maximizing the returns by reducing the risk.
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Re-balancing
Portfolio diversification enables re balancing of the portfolio. For instance, if in the year 2017, the housing development companies are expected to do well. And pharma companies are expected to perform well in the year 2018. In that scenario, a portfolio having housing development companies stocks can start to book profits in the year 2017. Meanwhile, the amount can be invested in further adding pharma stocks to the portfolio as they will give more returns in the next year. Therefore, diversification allows re balancing.
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Preserves Capital
Some investors invest in the market with a view that their capital must not erode. Limited rate of return is not a problem for them. In such cases, diversification of the portfolio is very handy. Diversification protects the capital. Investing in different stocks reduces the risk. It lessens the impact of any drastic downfall in any sector or any stock. Furthermore, diversification is not only a way of risk management but also an investment strategy that many investors apply.
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Hedges Portfolio
Diversification of portfolio enables hedging of the portfolio. Hedging is a risk management strategy. A diversified portfolio helps the investors in making returns during bull as well as bear markets. In the past few years, the investors who have diversified portfolio made more money than who invested in limited stocks. To put in another way, diversification off sets the risk by giving positive returns in one sector when another sector is giving negative returns.
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Adjustment
The diversified portfolio provides the investor an opportunity to adjust as per the suitability. Adjustment can be in the form of stocks in the portfolio, the risk-taking ability, etc. For example, a young investor can expose his portfolio to stocks that are more volatile and risky. On the other hand, an aged investor may adjust his portfolio with stocks that are less risky and where limited returns can be made.
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Meet Personal Needs
Investors invest his savings into the stock markets. By making a diversified portfolio, the investor has the opportunity to withdraw the money at his will. Life is uncertain and you never know when you need the funds. Furthermore, when the savings are put in stock markets it becomes difficult to pull out the money from there. However, a diversified portfolio shall always have some stocks giving positive returns. In such case, the investor can withdraw the money by selling the profitable shares. Therefore, the investor does not face any cash crisis in any situation.
Conclusion
With so many benefits, you must have realized how important it is to diversify your portfolio.If you have not considered diversification yet, it is still possible and you must do it! It will reduce your risk and fetch you higher returns.
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