What is the importance of diversification in investment strategy ?


What is the importance of diversification in investment strategy?

Imagine you have 50 eggs in a basket. You plan to organise an outdoor house-warming party with your friends. You have decided to make egg cutlet for the starters. Now you are carrying all the eggs together in a basket to the backyard but guess what? You stumble upon a small rock and the basket falls from your hand. Definitely a bad day! Most of the eggs will be spoilt in this case. If you would have instead kept the eggs in different trays and brought them 1 by 1 there is a better chance of more eggs to be fine.


The saying "don't keep all your eggs in one basket" holds true in the field of finance as well. The whole collection of eggs in finance is termed as a portfolio and the individual trays are called the asset classes.

Portfolio: A portfolio represents the total of all the different investments you hold. For eg. if you have 5 lakhs at disposal for you and you choose to keep 1 lakh in a gold ETF, 2 lakh in equity stocks ( different sectors), 1 lakh in debt funds and 1 lakh in government securities, then the 5 lakh is your total portfolio which is diversified into 4 asset classes.

Now, before I answer what is the need for keeping your money in different asset classes let me tell you some facts about different asset classes.
  • Equity: Equity is one of the riskiest asset classes among all. When you buy stocks you technically buy ownership stake in a company. So your return completely depends on the performance of the company. When a company performs well, you may get returns of 100% but when it does not you can lose your principal amount as well.
  • Real Estate: Real Estate is the second riskiest asset class after Equity. One of the major examples is the 2008 crisis when the property rates reduced to half the original prices. Other factors that make it more expensive is the maintenance cost, locality fees and the property taxes.
  • Commodities: When it comes to commodities different commodities carry different risk. For eg. Crude oil price is highly volatile (now even more because of the shale oil). However, Gold which is called the safe haven investment is a little less volatile and in the long term has always shown some increment in value.
  • Fixed Income: These are less risky investments and include government securities (treasury bills), bonds, debentures etc. which carry a fixed interest to be paid on the principal. Usually the returns are lower as compared to equity but you can be more sure about the security of your principal amount if you have invested in debt fund will a maximum exposure of 10% in a single company's debt.
  • Cash: This asset class as we all know is the highly liquid asset class and you can buy anything with cash. However, it is not a good idea to keep a lot of cash with you because it loses its worth with time due to less return in saving account and inflationary effect on prices of goods.
What is the need for diversification of your portfolio?

  1. Need of Fund: Let us Assume Anil has a 3 years old daughter and in the next year he will enrol his daughter to school. He will need 1 lakh for admission and he has invested 1.5 lakh in equity for the same, which he plans to withdraw 1 month prior to admission. Now think if the COVID-19 situation arises, then instead of his investment reaching above 1.5 lakh, he might have around 75 thousand due to massive drop in stock prices. This will make a stressful situation for him. Therefore it is necessary for him to know that he should keep 1 year worth of expenses in fixed income securities because they are lot safer and will not hinder the financial planning. The ideal way for him would be to keep 1 lakh in a debt fund for his daughter's admission and 50 thousand in equity for high growth (assuming he doesn't need the fund in immediate future).
  2. Mitigating risk and return: Also just like all eggs get spoilt due to keeping them in one basket. Similarly if you keep all your disposable money in one investment avenue and that investment avenue doesn't work out well, you will cause a major dent on your portfolio. For eg. If you are invested in a debt fund, which has a certain company's debenture in the portfolio and that company goes bankrupt, then you will lose a substantial amount of money as well as have negative returns throughout the portfolio. Instead if you could diversify into different asset classes, one asset class's loss can be set off by profit from other asset classes. A person who has very high expectation from his portfolio will have more money put into risky asset class investments.
Hope you have understood why is it necessary to diversify your portfolio!

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Thanks for reading!
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