How Diversification Works?
Diversification helps to reduce risk by allocating the investment capital across various sectors and companies having low correlation amongst them. This in-turn fetches higher portfolio returns with optimal level of risk as portfolio performance is not dependent of any particular sector or companies.
The essence of diversification is to protect the investment portfolio from various risks such as business risk, operational risk and so on.
For example, suppose Mr. Amar has capital of Rs.10 Lakh and he invested his entire amount in one stock of LTC Ltd which majorly exports leather to United States of America. In few months, due to some political reasons, the USA banned imports of leather from Asian countries including India. Due to this event, LTC Ltd business will face a dent as its major revenue source was from United States.
In above case, Mr. Amar’s investment portfolio will be impacted negatively and his investment value will deteriorate. This was because he had invested in only one company and any dent on that company will have higher impact on the portfolio returns. The case would have been different if Mr. Amar would have diversified his portfolio in 20 different stocks.
“Diversification is not putting all your eggs in one basket”. The goal of diversification is to reduce risk.
The Brighter Mind Approach
We, at Brighter Mind, believe that optimal diversification is essential to preserve capital in the dynamic risk environment in investing in equities. By adopting this strategy, we not only diversify the investment into different sectors, but also expand our exposure towards quality businesses in those sectors.
Many investors think that diversification dilutes the portfolio returns. But we believe that over a longer run, a diversified portfolio comfortably outperforms the concentrated portfolio. This is because, with proper diversification, we add width to our portfolio to absorb the short-term market volatility.
Diversification also adds another dimension at the time of portfolio rebalancing as we can easily add a new attractive stock opportunity to our portfolio by booking partial profit from other portfolio companies without straining our financial position.