Portfolio Diversification: What It Is, Why It Matters, and How to Do It Effectively

Portfolio diversification is the strategy of spreading investments across various assets to minimize exposure to any single asset or risk. It's the classic "not putting all your eggs in one basket" approach. Diversification aims to optimize risk-adjusted returns, ensuring that if one investment performs poorly, the impact on the overall portfolio is mitigated by the better performance of other investments.

InvestMates check portfolio diversification on various factors such as:

While how many investments a portfolio should have is very subjective, as per standards the recommended number of investments for stocks can be between 10 - 15, and for mutual funds, it is around 9 - 12 funds. The very common mistake most investors make is they invest in more than 30 - 50 stocks and in many cases, we have seen them investing in more than 100+ investments.

The reason why investing in too many stocks or funds can be detrimental is that it can lead to over-diversification, which means that the portfolio becomes so diversified that it loses its ability to outperform the market or achieve the desired risk-return tradeoff. Over-diversification can also increase the transaction costs, management fees, and tax implications of the portfolio, which can erode the returns over time. Moreover, over-diversification can make it difficult for the investor to monitor and rebalance the portfolio, and to keep track of the performance and prospects of each investment.

Therefore, it is advisable to invest in a reasonable number of stocks or funds that can provide adequate diversification without compromising the portfolio’s efficiency and effectiveness. The optimal number of investments may vary depending on the investor’s capital, goals, risk tolerance, and time horizon, but a general rule of thumb is to invest in the minimum number of stocks or funds necessary to achieve the desired level of diversification. The key is to choose quality over quantity and to focus on the diversification benefits rather than the diversification costs.

If you haven't taken our risk profile survey we have in our portfolio dashboard I highly recommend taking that. We have clearly shown the right asset allocation personalized to your profile as a standard. Without knowing one’s risk appetite and investment objectives it becomes very hard to tell what is the right type of assets one should have in their portfolio.

Generally, asset diversification would mean adding different types of assets to the portfolio such as stocks, bonds, gold, mutual funds, fixed deposits, real estate, etc. The objective is to reduce portfolio risk and volatility, and enhancement of portfolio return and performance, by investing in asset classes that have low or negative correlations with each other. This means even if equity markets go down and you have Fixed deposits or debt investment or Gold you will still generate returns.

One should not have more than 70% exposure to only one asset type. Having a minimum of 3 asset classes is best to start with. A person in their 20s having moderate to aggressive risk appetite and minimal capital can start with 2 - 3 asset classes if you add directly in 5 asset classes with minimal capital that may over-diversify and not generate optimal returns. While someone with a large capital of at least 1 crore and above must think of different asset classes for investment.

Investors should also consider the diversification within each asset class, such as the sector, geographic, and style diversification within the stock market, and the issuer, maturity, and rating diversification within the bond market.

Sector diversification is a type of portfolio diversification that involves investing in different sectors within an asset class, such as technology, health care, energy, or consumer staples within the stock market. Each sector has its own risk-return profile and correlation with other sectors. For example, technology stocks tend to have higher returns and higher risks than consumer staples stocks and tend to be positively correlated with innovation. Healthcare stocks tend to have moderate returns and moderate risks than energy stocks and tend to be negatively correlated with oil prices.

As a rule of thumb what we recommend is at least having 8 - 10 sectors in a portfolio without any one sector allocated more than 30% investment. This means your portfolio may have investments in Technology, Financial Services, Healthcare, Energy, Infrastructure, Consumption, etc. but one sector should not put your entire portfolio at risk. Someone who has a high expertise in a particular sector, key market insights and closely tracking and monitoring you should avoid taking that kind of risk.

You can check your portfolio sector diversification in InvestMates portfolio dashboard stock analytics we have given a detailed breakup of your sector allocation. Showing what stock or mutual fund falls under which sector and how much percentage of your total current value is in each sector. You can also compare your sector allocation with the Nifty50 sector allocation and check the high-performing stocks.

Geography allocation means investing in assets across regions and countries that can help investors reduce the impact of market downturns in one region, and capture the opportunities and growth in another region. Geographical allocation can also help investors hedge against currency fluctuations, inflation, and political instability. However, geographical allocation also involves some challenges and risks, such as higher costs, lower liquidity, and information asymmetry.

Taking advantage of growing regions and economics can optimize investors portfolio returns depending on a clear strategy and conviction on which region or country market to invest in. The safest option nowadays is international ETFs or overseas mutual funds. Investors must also consider the high costs that come associated with these like expense ratios and fund managers and their performance over more than 3 years to make an informed decision.

I have tried to explain above the parameters that we at InvestMates use to asses portfolio diversification however there is no hard and guaranteed rule that this is the best way to diversify, but as per our data portfolios that has this kind of diversification has shown high resilience in different market conditions and generated steady returns for investors.

We have built comprehensive portfolio analytics that will show you if you lack any of the above-mentioned diversification standards and how you can add it and optimize your portfolio to personalize your risk appetite. You can check our inbuilt screeners for debt funds, international funds, and top ETFs, high-performing sectoral stocks to fill the diversification gaps.

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