While choosing the asset classes, investors should know the risks and rewards connected with every investment class along with its features to decide if a single or a mix of asset classes is the right bet to meet their requirements.
There can be various criteria to classify asset classes. For instance, as per the location or the markets, assets are categorized as domestic securities, foreign and international investments, emerging markets and developed markets. However, the popular asset classes in India are fixed deposits, equity mutual funds, debt mutual fund, and gold, among others.
Investors diversify into different asset classes to suit their financial goals and objectives. However, while choosing the asset classes, investors should know the risks and rewards connected with every investment class along with its features to decide if a single or a mix of asset classes is the right bet to meet their requirements.
Purpose of Diversification
The basic objective of diversification is to reduce risk. But can’t one do that by investing only in ultra-safe government schemes such as PPF, NSCs and RBI bonds? No, because investing in these instruments will reduce the overall returns significantly. Investing 100% in debt options won’t help meet future needs. Investors should have some growth oriented assets such as equities to increase returns. Besides lower returns, the income from debt products attracts higher tax rates. Interest is taxable for most debt instruments, so the post-tax return will be very low and won’t beat consumer inflation. Investors may have to forgo several of their financial goals if they follow this risk-free strategy.
Return from a Diversified Investment Portfolio
Figures are returns from the asset classes during the financial year. Negative returns are marked in grey.
How to create a Diversified Investment Portfolio?
There are various ways through which an investment portfolio can be diversified:
- Diversify through asset allocation
- By determining investor’s risk appetite
- By diversifying within an asset class
- Investing through equity mutual funds
1. Diversify through Asset Allocation
The simplest way to diversify is through asset allocation. This means spreading your investments across a range of asset classes such as stocks, debt, cash, mutual funds, bonds, real estate, and gold in a systematic manner. That way if equity markets give poor returns, you can offset it with gains from investing in fixed income and gold.
2. What is the Investor’s risk appetite?
The ideal asset allocation for an investor depends on the investor’s risk appetite, the higher the risk appetite of the investor the higher proportion of his investment should be in equities. In order to determine your risk appetite, you should consult an investment advisor who can guide you on the details.
3. Diversify within Asset Classes
It is important to remember to diversify within asset classes as well which is especially true regarding equity investments. It is important to remember that while buying equities is an important part of a diversified portfolio, holding similar stocks is a risky practice. IT stocks had given investors great returns during the period of 2013-2015 (an annualized return of 31%).
However, the performance for the sector from 2015 onwards has been negative with an annualised return of around -3%. Investors who manage their own stock portfolios need to avoid concentrating into any one particular sector or stock to avoid such a situation.
4. Invest through Equity Mutual Funds
Another way to a diversified equity portfolio is to invest through equity mutual funds. Equity mutual funds are managed by investment experts who ensure that the holdings of the fund are diversified across different sectors. By buying an equity mutual fund, an investor gets the benefit of owning a diversified equity portfolio that is also actively managed by investments experts.
Diversification is a tool that helps all types of investors from the small-time individuals to the largest institutional investors. Until a few years back, it was hard for individual investors to reliably measure whether their investments were appropriately diversified. However, with the introduction of digital advisory solutions, investors can now conveniently diversify their investments.
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