Tavagapedia

Asset diversification

Asset diversification refers to the act of dividing one’s investable capital between different asset classes to manage risk better. It was first coined by Harry Markowitz, one of the world’s most illustrated economists.

EXAMPLE

we may invest in equities as well as debt instruments for different money goals, diversifying our assets in the process. Asset diversification guides our asset allocation better.

Under the same circumstances, equity and debt instruments usually fare the opposite of each other. The two have a negative correlation so in case of a fall in prices in one there may be an equivalent rise in prices in the other. Asset diversification can help in balancing returns in case of the extreme poor performance of one of them.

Know more

Markowitz wanted to calculate the portfolio risk and returns quantitatively. According to his theory, the returns on the portfolio will be the average returns on all the asset classes which the portfolio holds, where the risk which is measured in terms of standard deviation of the asset class will be less than the average standard deviation of all asset classes.

Asset diversification formula
Source: Tavaga

Where, σp is the standard deviation of the portfolio or the portfolio risk, W1 is the weight of 1st asset in the portfolio, is the variance of 1st asset in the portfolio,W2 is the weight of 2nd asset in the portfolio, is the variance of 2nd asset in the portfolio, Cov1,2 is the covariance of 1st and 2nd asset in the portfolio.

How to diversify your portfolio?

When an asset diversification is intended, Major focus should be on the following:-

  1. Your risk-taking ability
  2. Returns intended
  3. Time frame in which returns are intended
  4. Exposure
  5. The flow of money to meet your daily expenses
  6. The goal of investing in an asset class
  7. No of people dependent on your daily income

Portfolio can be diversified:-

  1. Focus on the characteristics of the different assets
  2. Invest in different types of assets based on the risk & returns
  3. Keep a track of the various assets in which the amount has been invested
  4. Fix a time frame and exit if the desired returns are not generated till then
  5. Keep an eye on the amount of returns generated
  6. Look at the underlying performance of the asset in which the money invested

There are various asset allocation models that are customised as per an investors risk-taking ability and returns expected. It is recommended that investment should be made in assets for the long term (more than 5-10 years) which will help increase returns and the final amount of investment made.