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.
Vertical Diversification
In order to design the portfolio, we follow vertical diversification strategy wherein we diversify the portfolio across different industries and sectors. This helps us reap the benefit of all the major sectors and provide buffer to the portfolio. Also, we get plethora of investment options when we implement vertical diversification.
Horizontal Diversification
To arrive at a better portfolio mix, we also follow the horizontal diversification of our portfolio. Under horizontal diversification, we identify different companies within the industries having different business models and expertise in their segment. This helps us spread our portfolio root even further.
Reduce Portfolio Risks
With diversification, we reduce the overall portfolio risks caused due to market fluctuations. This is possible because the capital is allocated across different market-capitalisation and sectors. It helps us safeguard the investment capital and allow the overall portfolio to grow without any significant dent.
Good Returns
When the portfolio is well-diversified, the risk is mitigated to the optimum level and the return potential of the portfolio is uplifted. This is because when we carefully diversify the portfolio, we avoid getting over-weight on any particular stock and hence any unlikely future event detrimental to any industry or company does not have significant impact the overall portfolio returns.
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.
