By: Tavaga Research
Asset diversification means investing your money in different places so as to benefit from the balancing effect (eg. in case one of your investment is losing money another one making money can balance the effect), it basically has the underlying principle of “don’t put all your eggs in one basket”.
Asset diversification can then be divided into two parts:
- divide between different asset classes and
- divide between different assets within the same asset class
To understand this further, asset classes are mainly divided into three broad headings:
- debt and,
- cash equivalent/money market instruments.
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One must divide between all these asset classes w.r.t. different requirements i.e. stocks are used to increase wealth through high risk high returns, bonds/debt instruments are used to get a defined/fixed return; and money market instruments are used mainly to fulfil immediate liquidity needs but may still give a low return on the money invested.
And even when dividing within the same asset class, one must invest in different instruments within the asset class. Eg: Buy stocks of companies in different sectors (such as banking, FMCG, etc.); in debt one can invest in bonds/fixed deposits/certificate of deposits; in cash equivalents such as saving bank account/physical cash/liquid funds etc.
Now the ratio of the diversification is unique to every person, for someone who is younger and has a higher risk appetite they can dedicate a higher percentage to equity and lower in debt.
The main benefits of asset diversification are:
- Minimisation of loss risk: With asset diversification one can minimise their losses from any one asset class. This happens because if one asset/asset class is performing poorly another asset/asset class is performing better than average. This helps balance out the result, and reduces loss prospective in portfolio.
- Preservation of Capital: Diversifying assets helps reduce chance of loss of capital. Investment in debt instruments assure fixed return and safety of capital, having this as part of your portfolio ensures capital preservation.
- Generating better returns (at similar levels of risk): With asset diversification there is a higher possibility for better returns. There are market rallies when certain asset classes perform extremely well and having a diversified portfolio better ensures you benefitting from this. Having equity during a bull market phase allows for higher than average returns. And having debt during a bear market allows decent returns even with drop in equity portfolio.