What is Portfolio Diversification?
Portfolio diversification is a risk-management strategy wherein an investor invests in different types and classes of assets and investment vehicles, with a guiding principle that it will help in containing the risk associated with a single asset. The rationale behind diversification is similar to the old adage of not putting all eggs in one basket.
A diversified portfolio can include investments in different types of stocks, mutual funds, exchange-traded funds, futures and options, and bonds.
Benefits of diversification
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Risk mitigation: One of the key benefits of a diversified portfolio is that it reduces the investment portfolio’s total risk. By investing across asset classes and sectors, the overall impact of market volatility is mitigated.
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Increased stability: A diverse portfolio is also more stable than a concentrated one, as there is a high probability that all investments are not expected to perform poorly concurrently.
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Long term goals: Diversification is specifically good for long-term investment goals, as investing in a single asset over long-term significantly increases the risk of loss. Hence, an ideal mix of the two or more investment assets to ensure investment success in case of long-term goals.
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Peace of Mind: Diversification brings peace of mind as investors are satisfied that the risks are managed, and the fallout of any unexpected market volatility may not impact the entire portfolio.
Pitfall of diversification
A serious pitfall of portfolio diversification is too much diversification, when an investor has purchased so many assets that it is difficult to keep a tab on them. In such a scenario, the investor loses sight of investing goals and strategy.
Types of Portfolio
- Aggressive portfolio: It refers to an investment portfolio which aims for higher returns and often undertakes higher risks to achieve this objective.
- Defensive portfolio: It refers to an investment portfolio which focuses on low-risk assets. It is best suited for risk-averse investors.
- Income portfolio: It refers to an investment portfolio where investor aims to gain from dividends or other recurring benefits provided to shareholders
- Hybrid portfolio: It refers to a portfolio where investment is made in a mix of assets from different classes and sectors. The hybrid portfolio is a balance of high-yield equity returns and fixed income instruments. It is the type of portfolio which exemplifies portfolio diversification.