The key to investing is to make a balance between the risk and the return. Conservativeness curbs return, aggressiveness pumps risk! A sweet spot between them is all you want.
Hence, you should know how to arrive at a trade-off between the two. And it can be summarized in a word: ‘Diversification’. It is the art of spreading your investments in various categories of assets, which helps earn the desired returns without exposing your portfolio to high risk. Diversification helps make an ideal portfolio.
Want to learn the art of diversification? Let’s get started.
How much diversification is enough?
You should have heard that “Don’t put all of your eggs in one basket.” It’s no rocket science that diversification helps you cut down your exposure to a single sector/stock. But you should also remember that ‘Excess of anything causes more harm than good.’ Let’s understand both sides of the argument.
Diversification of your portfolio indeed helps you in reducing the risk. It can also offset losses. The loss incurred by one stock can be set off by the gains in other stocks. But excess diversification may decrease your returns rather than increasing them. After all, the quality exceeds quantity.
Let's understand it with an example. Suppose you have invested Rs 100k in the stock market. And you have invested Rs 2k in 50 stocks. If one of your stocks doubles itself, you’ll tap your back, claiming how you picked a multi-bagger! But you will get back to reality when you realize that the overall increase in the portfolio was a mere 2%!
Although over-diversification is harmful, excess concentration of portfolio is no good as well. The concentration of investments increases the overall risk and volatility of your portfolio. If one stock doesn't perform as per your expectations, the possibility of getting high returns will fade away. The capital invested may diminish as well if you haven't diversified enough.
How to build an ideal equity portfolio?
By now, you should have realized the importance of adequate diversification. And if you wonder how to diversify your portfolio? Well, here’s how -
If you have 4-5 stocks in your portfolio, there is an enormous risk of capital erosion. It is due to the inappropriate selection of stocks. At the same time, investing in 40-50 stocks isn't an apt option to get high returns. So, 15-20 stocks are the ideal diversification mix.
You can’t call it diversification if you have invested 30-40% in a particular stock. So, it’s advisable not to invest more than 8% of the total portfolio in one company. And as a standard practice, the 4-8% exposure to a single stock is considered apt.
Now, if you also hold mutual funds and a particular company forms a part of that fund’s portfolio, you have to take that into account as well. Be mindful of this kind of overlapping. Only then, you can diversify well.
Diversification should not be restricted to a particular industry. One unfavorable event may eat away all the returns if you have focussed too much on a sector (like the pandemic that destroyed the hospitality sector). Therefore, you should add an ideal number of 5-6 sectors in your portfolio with not more than 25% investment in a specific sector.
But the most crucial point of all is - Correlation. As we had written in a previous article on Diversification -
“Speaking of the stock market, if you own shares of a company in the auto sector, say, Maruti Suzuki, it may not help a lot adding another from auto ancillary, like Motherson Sumi. You’d be better off diversifying both across and within asset classes.” because “[..]that’s a better guard against market volatility.”
Long story short, a portfolio of 15-20 less-correlated stocks, with a maximum of 8% investment in each and not more than 25% allocation to a single sector, is an ideal portfolio diversification mix.
Investing in other instruments
An ideal investment portfolio isn't made entirely from equity. It maintains a balance between the risk and returns by appropriate allocation in different asset classes. That is why we present you with the best non-equity instruments to create an ideal portfolio.
In the world of stock markets and crypto, gold is an underrated gem. Gold and the stock market are inversely related. So, you should have a backup if stock markets fall. No wonder, Gold is considered a ‘safe haven’. Therefore, you should invest 10-20% of your portfolio in gold. But many people hesitate to buy physical gold due to its security and charges. Worry not.
Sovereign Gold Bonds (SGBs) are the most effective way to invest in gold. It solves most of the said problems. What's more, you can earn nominal returns besides capital appreciation.
These and debt mutual funds are the best instruments if you want more returns than FD at a lower risk. Bonds of the AAA category are considered safe. And the risk of insolvency is next to zero. But they will fetch you lower returns. After all, risk and return are directly related. But don't run after extra returns by investing in risky bonds. You may end up losing your capital as well. If you want to, it's better to invest in equity.
Besides, as per your investment objective and risk profile, you may also choose to diversify across international stocks and several other instruments.
The bottom line
If you have read the entire blog carefully, you would have noticed how difficult it is to create a good investment portfolio. If it is that easy, everyone would have invested in stock markets. But that is not the case.
Don't get us wrong. We don't intend to discourage you from investing in stock markets. It is natural to make mistakes as long as you don't do it again. As it is rightly said, “The greatest mistake is to be afraid of making one.”
In the end, remember that these are just standard recommendations and may not exactly be the same for all. Different people have different risk investment goals and risk appetites. Accordingly, you should find out your portfolio diversification mix and invest only after the research part is taken care of.
And as we always say -
Invest in what you know.
Anyway, how many stocks do you have or prefer to have in your portfolio? And why? Tell us in the comments.