What does Diversification mean to Investors?

Just last week I came across the following post.

What do you think?

Why has Zuckerberg’s net worth suddenly dropped from $122B to $43B while Buffett’s net worth increased from $104B to $109B?
Because most of Zuckerberg’s net worth is tied up in Facebook stock. As a result, the major decline in META stock value (about 60 per cent down from a year ago, when it became Meta). In simple words, we can say his portfolio was concentrated and tied up to limited stocks and due to a major decline in particular stock price Zuckerberg’s portfolio valuation declined.

Zuckerberg is not the only Billionaire who lost his net worth during the turmoil in the market Others have also lost their net worth.

Bill Gates $26 billion, Jeff Bezos $44.4 billion,  Elon Musk $2.55 billion etc.

In the case of Warren Buffett, his portfolio consists varieties of stocks so some of the stocks declined but some of them gained also that’s why his net worth increased during the same period.

Volatility in the market is by inheritance. It will never move as per our wish or we can’t predict its movement also, but we can prepare ourselves using Diversification while investing may help us with this concern.

In a bull period we beat inflation numbers by a huge margin, but what about the bear/range-bound period? If our committed goal’s matured in this bear phase then! We are all getting confused about investing at this point in time. But truth is that unfortunately to date we don’t understand properly what investing is. What Diversification is and what is its importance?

Definition

Diversification is a risk management strategy which dilutes the risk by distributing a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk.

Diversification aims to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others.

Types of Diversifications

As investors think of ways to diversify their holdings, there are dozens of strategies to implement. Some of the following strategies can be used to improve the level of diversification within the portfolio.

  1. Asset Classes:

In this strategy, capital is distributed among asset classes like Stocks, Bonds, Commodities, Real Estate, ETFs and Cash or cash-related instruments.

  1. Industry/Sector

There’s a huge difference in the way different industries or sectors work. When investors diversify across different industries, they become more protected against sector-specific risk.

  1. Growth / Value

Stocks tend to be broken into two types Growth and Value.
Growth stocks tend to be riskier as the expected growth of a company may not materialize and on the other hand, have infinite potential to generate even greater returns than the expected growth.
value stocks tend to be more established, stable companies usually carry less risk.
By distributing capital in both, an investor would capitalize on the future potential of some companies while also recognizing the existing benefits of others.

  1. Large / Small

By allocating capital to both, we insinuate potential growth through lower-cap stocks and safety through large-cap stocks.

Diversification doesn’t mean we buy anything and hold onto it until the end of the world. The basic concept of diversification is to keep distributing your money among all asset classes to reduce risk. Reassess the portfolio frequently and redistribute from higher risk to lower risk. Because we don’t know which asset class will perform and when it will perform in a particular period. Does that mean we don’t know where we are going?

Diversification – Benefits and Drawbacks

In theory, holding investments that are different from each other reduces the overall risk of the assets you’re invested in. If something bad happens to one investment, you’re more likely to have assets that are not impacted if you were diversified.

The primary goal of diversification is to manage risk. By allocating our capital across different asset classes, industries or sectors, we have the strength to withstand market shocks that affect each of our investments. Diversification may also increase the chance of hitting positive news.

However, there are some disadvantages also wrapped with diversification. Diversification is time-consuming it also incurs transaction costs and brokerage commissions. More fundamentally, by protecting you on the downside, diversification limits you on the upside—at least, in the short term. Over the long term, diversified portfolios do tend to post higher returns

Benefits

  1. Reduce Portfolio Risk.
  2. Protect against Volatility.
  3. Offer Higher Return in Long Term.
  4. More Enjoyable for Investors to research new investments.

Drawbacks

  1. Transaction Costs involved.
  2. Time-consuming.
  3. Restrict short-term gain.
  4. overwhelming for newer, inexperienced investors.

Bottom Line

Because Diversification is done for risk management we should choose proper schemes for diversification. Schemes for diversification should be inversely correlated. Inversely correlated means when one scheme is going down another scheme will go up and hence loss from one scheme is compensated by another one.

In the short term, the market is always irrational & in the long term, it’s always rational if you respect and stick to your Risk Management Strategy.

“What the wise man does in the beginning, the fool does in the end”

– Warren Buffett.

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