Understanding diversification ...

Mutual fund companies highlight the benefit of diversification. What exactly is it and how does it help one? Let us understand the meaning, benefits and limitations of diversification here ...

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Understanding diversification

Mutual fund companies highlight the benefit of diversification. What exactly is it and how does it help one?

When we invest our money in any investment, there is a lot of work required to study and analyse the same. However, there is still a risk of one’s judgment being wrong. There is a protection available against such errors of judgment. Invest across different companies representing different industries. However, do so only after identifying good companies. This would ensure that even if your judgment is wrong in a few cases, or if things do not turn out as expected, at least some part of your investment portfolio will not disappoint you.

In reality, a well-diversified portfolio tends to protect downside even while allowing one to participate in good part of the upside.

Is there any downside to diversification?

While diversification protects the portfolio from complete erosion, there would always be some part of the same portfolio that would outperform the whole. So if you are stickler for best performance, you are likely to be disappointed, as the whole portfolio cannot beat every single component of itself.

What care should one take while diversifying?

While comparison between the portfolio and one part of the same may make the portfolio look underperforming, it is unfair to do such a comparison. If we go back to the opening paragraph, we discussed that the purpose of diversification is to protect oneself against any unexpected, negative outcome. This means, if no part of your portfolio is delivering a disappointing performance, it is not properly diversified. Imagine, if all the components of your portfolio were rising in value simultaneously, what would happen if the present situation reverses? There is a possibility that in such a situation, the entire portfolio would witness a drastic fall in market value.

The key is to invest across companies, across industries, across asset categories and across geographies. In such a case, the portfolio is most likely to exhibit smooth performance, but as we have already mentioned earlier, it would underperform some part of the market.

- Amit Trivedi