You include different types of foods in your diet to ensure you remain healthy. Similarly, investing in highly volatile financial instruments is risky. Therefore, diversification becomes important to mitigate these risks and even out market fluctuations over a period of time.
Generally, it is perceived that the best investments are those that provide stable returns, have no risks, and ideally offered by the government agencies. Alternatively, you may consider investing in real estate or gold where the returns are primarily associated with inflation.
You may also be from the school of thinking that considers profit booking important to earn better returns on their investments. The primary assumption for this strategy is to exit your investment when the prices are high while avoiding price decreases. Another assumption is that you should cut your losses if your chosen investment is not performing well and shift to another better performing product. However, timing the market correctly is often not possible even for seasoned investors. This is where diversification becomes important.
Making Incorrect Investment Decisions
You may consider investing in provident funds as a safe and secure investment option. However, for several decades now, the corpus of such provident funds has been invested in income-related securities. Therefore, millions of investors like you have not earned very high returns through this investment strategy.
A few years ago, the government launched the National Pension System (NPS). This fund invests your contribution into safe bonds along with other investment options like equity.
Diversifying Your Portfolio
When you talk about diversification, it does not necessarily mean maximizing your returns on investment. When you hold a diversified portfolio, you are able to manage investment risks in a better way.
You may invest in real estate buying one property after another. You ignore all principles related to diversification because you consider that returns on real estate investment are higher than other financial products. However, you do not consider your need for liquidity, growth, and income when you invest only in one asset class. When you invest heavily in only one kind of asset, you expose your capital to several unforeseen risks.
Forecasting the risks from past performance or assuming that risk may be mitigated by making accurate present investment decisions or managing risks when certain events occur is not possible and unrealistic. Prices of different asset classes rise and fall and predicting these movements is almost impossible. Therefore, diversifying your portfolio by including different types of investments is an excellent way to mitigate the investment-related risks.
One excellent way to achieve diversification is to invest in mutual funds. You may choose multiple funds based on your financial objectives, risk appetite, and investment horizon. Including equity, debt, cash, and cash-related in your overall portfolio is advisable.
Steps involved in asset allocation
The best method to achieve diversification is through asset allocation. In the first step, determine your investment objectives and current financial situation. Next, take into account your risk appetite and investment horizon. Based on these variables, you may allocate your funds in different types of products.
When you invest for the long-term, investing in equity-oriented funds is advisable. As your financial goals draw closer, it is recommended that you shift your investment to debt funds for stable returns. Asset allocation is not a one-time procedure and you need to periodically review your portfolio to make necessary modifications.
Investing in funds also gives you the advantage of a professionally managed corpus. Fund managers are experienced professionals who are able to make accurate investment decisions to maximize returns for investors.
Asset allocation and diversification are the two best strategies to minimize investment risk. Hence, it is of utmost importance that you should take necessary action at the earliest.