Diversification is one of the most important rules in finance and is a key principle concept that you absolutely need to understand if you want to succeed in the stock market.
1. What exactly is diversification, and why is it important?
Diversification essentially means that your investments should look like a pie.
Your investments should be bifurcated into different asset classes.
You must often hear stories about how people buy a house on EMI, years pass by, they continue to pay 25,000 per month, but are still not given possession of the house.
This becomes a back breaking problem, since all your money is invested into a single asset class.
100% of your investment goes into the house. It can become a massive problem if something bad happens to it.
You should invest across different asset classes, and you should diversify within each asset class as well. This allows you to hedge your risk.
2. What are the major asset classes across which you can invest?
There are 5 major asset classes that you can use to diversify your assets.
Here, you are buying a business i.e. you are buying ownership in a particular company. E.g.- ITC, HUL, Tata Motors.
The government and big companies take loans from people. These are called bonds. You are paid a rate of interest on bonds.
It is to be noted that, unlike equity, you don’t become the owner of the company or the government when you buy bonds. You are simply loaning out money.
iii. Real estate
This would be commercial property or rental property.
These would be gold, silver or oil.
Physical delivery of commodities can be a problem. For example, if you buy physical gold, storing and handling it can become a challenge. You should try buying these in digital form.
Commodities can give you hedging benefits. When the stock market goes down, gold becomes a safe haven for investors and hence its price goes up.
In such a scenario, whatever losses you’ve made in stocks can be compensated by the profits you make in the gold market.
Currently, the crypto market is way smaller compared to the stock market. But if it grows to become like the stock market in the next 30 years, the returns would be dramatically high.
Nonetheless, it would be advisable that you don’t invest more than 5-10% of your portfolio into cryptocurrencies.
3. How should you go about designing your investment portfolio?
You need to ask yourself a couple of question-
What is your age?
Second, what is your risk appetite?
If you’re young, you should invest your money for growth. Since you have age by your side, you can withstand the dips.
If you are slightly older, invest the majority of your money for monthly withdrawals. You should invest in stable assets, as it will bring you a regular income flow.
You should superimpose the aforementioned points with your risk appetite. If you’re a risky investor, you can allocate more of your funds to equity and cryptocurrencies.
If you are a risk free investor, debt and fixed deposits would make sense.
Let us create 2 profiles and try to outline how each person should design their investment portfolio.
We will not consider scenarios on extreme ends. If you are an extremely risky investor, you should probably invest all your money into cryptos. On the other hand, if you are extremely risk averse, you should invest in an FD.
Person 1: You are in your 20’s and are a balanced investor (Neither too risky, nor risk averse)
Debt- 10% (This depends on the market condition. If the market is stable or in a growth phase, keep very little debt. Invest mostly in equities.)
Commodities- 10% (Use commodities purely for hedging, in case the stock market tanks.)
You might wonder why real estate is missing from the list. This is because the real market in India involves a lot of frictional cost, and hence is not a very viable option.
Person 2: You are in your late 40’s/early 50’s and are a balanced investor as well.
Equity- 30% (Only large, stable blue chip companies.)
Here, the idea is to reduce volatility.
Should you invest in cryptocurrencies? Probably not. The market will take a long time to stabilise, and hence you should invest in only stable sources.
4. Key points to remember:
i. If you are a risky investor, cryptocurrencies and equity are a great bet. But, always hedge your risks. Either learn about future and options or invest in commodities.
ii. Don’t look at your house as an investment. You buy your house to live in it, so do not look at it as an investment in the traditional sense.
iii. If you are a risk free investor, invest a little bit of your money in an FD, and in passive mutual funds. Just make monthly SIPs and you will do well.
Hopefully, this article has given you clarity on how you can structure your portfolio. 🙂