Why Diversification is Important in a Portfolio

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LEARN portfolio diversification from the well known proverb, "Don't put all your eggs to the same basket". This is a best known proverb informing investors to the importance of portfolio diversification to cutting the risk. Through proper diversification, one can reduce the risk involved to a portfolio in a great extend but it required lots of plan and good effort. Below are the details on major required qualities of a diversified portfolio and the two available diversification methods for your knowledge:

To deal with diversification, one should determine the fund allocation to different asset classes prior to build a portfolio. This can be equities, fixed assets, mutual funds or any investments that can give profit to the investor.

The major advantage of diversification is its ability to protect the entire portfolio from various risk and volatility associated to various asset classes. Good portfolio diversification should have following qualities:

1. It should include variety of investments like stocks, mutual funds, bonds and cash etc. You can even select well performed Unit Linked Insurance plans that provide facility to decide and diversify your money across various funds from different asset classes on the basis of risk, associated with the product. Nowadays, people diversifying portfolios by including gold, commodity and real estate investments to there portfolio through various available investment options.

2. A portfolio that should have horizontal diversification exposure inside the asset class itself. For example, building a stock portfolio with large, medium and small cap companies and index funds or a mutual fund portfolio with diversified equity funds, large cap funds, balanced funds, mid-cap and small cap funds, sector funds and thematic funds etc. Cash portfolio with fixed deposits in different banks and different duration, Fixed Maturity Plans, bond funds and liquid funds etc..

3. To limit the industry specific risks, one should spread the investment across various industries. To avoid the location specific risks, one should spread investments geographically. This can be done mixing of domestic and international stocks and funds to the portfolio.

Below are the two known diversification methods for your knowledge:

Horizontal Diversification: This means the same type investment diversification. If you are investing is stocks through horizontal diversification, you are buying stocks of various companies i.e. large cap, mid cap and small cap and belongs to various industries.

It has three key advantages.

1. Investing across industries enable you to protect your portfolio from industry risks.

2. Adding Large cap stocks is a better idea to shield portfolio from huge market volatility because large cap stocks are comparatively low volatile.

3. Adding mid cap and small cap stocks enable you to tap the growth potentials as well as huge profit for long run.

Vertical Diversification: This is very broad diversification because it is investing in different types of securities. Through vertical diversification, you are protecting your amount by investing some amount to different asset classes as I informed previously.

With horizontal diversification, it lessens the risk of investing entirely in one asset class. But, vertical diversification protect your investments against both markets and economical changes.