Benefits of Diversifying Your Investment Portfolio for Your Financial Goals And How to Do It?

Investing your money is a crucial step towards securing your financial future and achieving your financial goals. Whether you are saving for retirement, buying a home, or building an emergency fund, investing is an effective way to grow your wealth over time. However, relying on a single investment strategy can be risky and limiting. This is where diversifying your investment portfolio comes into play.

Diversifying your investment portfolio is a key strategy for managing risk, optimising returns, and achieving your financial goals. By spreading your investments across different assets, you can reduce your overall investment risk, increase your potential for returns, and ensure long-term stability. In this article, we will explore 3 benefits of diversifying your investment portfolio and how it can help you achieve your financial goals.

Here are the benefits of diversifying your investment portfolio for your financial goals:

1. Reduces Investment Risk:

No investment is risk-free, and every investment has the potential for both profits and losses. However, diversifying your investment portfolio can help reduce your overall investment risk. By spreading your investments across different assets, you can minimise the impact of market fluctuations on your portfolio.

For example, if you invest all of your money in a single stock and that stock experiences a sharp drop in value, your entire investment portfolio will be affected. However, if you spread your investments across several stocks, mutual funds, bonds, and other assets, a drop in the value of one stock would not have a significant impact on your overall portfolio. This is because the losses in one asset would be offset by gains in other assets.

2. Optimises Returns:

In addition to reducing investment risk, diversifying your investment portfolio can also help you optimise your returns. By spreading your investments across different assets, you can take advantage of different market conditions and capitalise on different types of returns. For example, stocks tend to perform well during market expansions, while bonds tend to perform well during market downturns. By having a diverse portfolio that includes both stocks and bonds, you can benefit from both types of returns, regardless of market conditions.

Furthermore, diversifying your investment portfolio also allows you to benefit from different types of returns within each asset class. For example, if you invest in mutual funds, you can choose funds that focus on different types of investments, such as large-cap stocks or small-cap stocks. This way, you can benefit from the returns of different types of stocks and reduce the impact of market fluctuations on any one type of stock.

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3. Ensures Long-term Stability of the Portfolio:

Diversifying your investment portfolio can also help you ensure long-term stability. By spreading your investments across different assets, you can reduce the impact of market fluctuations on your portfolio over time. This is especially important for long-term goals such as retirement, where a sudden drop in the value of your portfolio can have a significant impact on your ability to achieve your goals.

Furthermore, having a diverse portfolio that includes different types of assets can help you weather different types of market conditions. For example, during a market downturn, debt instruments tend to perform well, which can help offset the losses in other parts of your portfolio. This can help ensure that your portfolio remains stable, even during periods of market turbulence.

Understand the Risk-return Spectrum for Right Portfolio Diversification

The Risk-return spectrum is an important concept for investors to understand as they make decisions about their portfolios. By balancing risk and return, investors can potentially achieve their investment goals while minimising the risk of large losses. This is typically done through diversification, which involves holding a mix of different types of investments to spread risk across a variety of assets.

When allocating assets to diversify your portfolio, it is essential to recognise that risk, and returns go hand in hand. That is to say; for every desired return, there is an inherent level of risk. Every asset class, such as stocks, bonds, real estate, and gold, or the type of mutual fund you choose, comes with its own unique level of risk and reward.

The Risk-return spectrum refers to the trade-off between the potential returns of an investment and the associated risk. It is represented graphically as a curve, where the investments with higher potential returns are located on the right side of the curve and are generally associated with higher levels of risk. On the other hand, investments with lower potential returns are on the left and are generally associated with lower levels of risk.

In general, the risk-return spectrum highlights the idea that investors must accept higher levels of risk if they want to earn higher potential returns. For example, equity and equity-oriented instruments are often considered to be riskier than debt-oriented instruments because they have the potential for higher returns but also have the potential for larger losses. On the other hand, debt-oriented instruments are generally considered to be less risky because they provide a steady stream of income but also offer lower potential returns.

While diversifying across asset classes is important, it is also crucial to allocate your assets in a strategic manner. Considering factors such as your age, income, expenses, and time in hand to achieve your goals can help you create a well-diversified strategy based on your risk appetite. If you have a high-risk appetite, you may allocate more of your portfolio towards equity assets. On the other hand, if you have a low-risk appetite, i.e., you are a conservative investor, you may prefer to allocate more of your portfolio towards fixed-income assets. If you are a moderate risk taker, you may choose to have a balanced mix of 60% equity and 40% debt.

The pyramid depicted above illustrates that large-cap funds are comparatively stable and carry lower risk compared to mid and small-cap funds but at the cost of lower potential returns. In a similar vein, fixed-income products and debt instruments pose low risk, while equity and equity-related investments are at the high end of the risk-return spectrum. It's important to note that high risk does not guarantee high returns.

So, diversification is necessary for mutual fund investment because it helps to spread investment risk across a variety of securities. By holding a mix of different types of mutual fund schemes, a diversified portfolio can potentially be less volatile and better able to withstand market downturns. This helps to reduce the overall risk of an investment and leads to more consistent long-term returns.

However, understand that over-diversification and under-diversification can affect your investment portfolio in different ways. Over-diversification can dilute the impact of strong-performing assets in your portfolio, leading to subpar returns. Whereas under-diversification increases the risk of loss due to the concentration of assets in a limited number of holdings. Hence, it is important to strike a balance and diversify your portfolio appropriately based on your investment goals, risk profile, and other factors.

While you can appropriately diversify your portfolio with the right mix of mutual fund schemes, selecting the best-suited mutual fund schemes involves evaluating both qualitative and quantitative factors. The qualitative factors include historical performance and risk-adjusted returns, while the qualitative factors typically include the quality of the portfolio, the fund manager's experience and style, portfolio ratios and concentration, investment processes and systems at the fund house, asset under management, etc. It is important to also consider your personal investment goals, risk profile, and time horizon. Just like different asset classes, each category of mutual funds has its own risk and reward profile, so it is crucial to take all of these factors into account when making a decision.

If you have defined your SMART financial goals and are searching for the appropriate mix of mutual funds to reach them within a specific time frame, PersonalFN's SMART Fund Explorer can assist you in diversifying your portfolio. Simply specify your SMART financial goals (such as buying a house, saving for a child's education, or retirement), choose a suitable timeframe for achieving your goal (e.g. 5 years or 10 years), provide the amount you need in today's terms, and indicate the lumpsum or SIP investment you can afford. After entering all of the required information, click on "Show Me My SMART Investment Plan."

The SMART Fund Explorer will present you with an expected return (% CAGR) and the value of the investment at the target date (calculated based on a nominal inflation rate).

The tool will also offer two investment plans (Plan A and Plan B), which will specify the fund categories to invest in, the asset allocation percentage, the potential returns of each category, and the weighted annual return contribution. You can choose a plan based on your risk tolerance.

Additionally, by signing up to PersonalFN's SMART Fund Explorer, you can access a list of the best-suited mutual funds according to your selected plan. This list, curated by PersonalFN's research team, can serve as a smart starting point for your mutual fund investment journey.

Final words:

It's important to understand that diversifying your portfolio is only effective if it is followed by consistent rebalancing. Rebalancing can be challenging, and many people struggle to do it correctly. This process involves realigning your portfolio, but many people are unsure of what the optimal realignment looks like. For example, if you have diversified your portfolio with a long-term focus on your retirement, you may be exposed to more risk if you don't rebalance by shifting from high-risk assets to low-risk assets as you approach your financial goal.

Therefore, it's crucial to keep in mind that both diversification and rebalancing are essential components of effective investment management. If you wish to evaluate your mutual fund investment portfolio and determine if it needs to be reallocated or rebalanced, sign up for PersonalFN's Mutual Fund Portfolio Review Service.

KETKI JADHAV is a Content Writer at PersonalFN since August 2021. She is an MBA (Finance) and has over seven years of experience in Retail Banking. Ketki specialises in covering articles around banking, insurance, personal finance, and mutual funds and has been doing it for over three years now.