Earning returns on your investments is not as easy as it seems. You cannot straight away invest in any of the available asset class which yields high returns. Investing requires proper due diligence on the part of the investor and will only generate fruitful result if proper asset allocation has been made which are in sync with the individual’s risk appetite and liquidity needs. While constructing a portfolio one must maintain a proper balance between risk and reward. Risk can be minimized by diversifying funds across different asset classes or within the same asset class. However, most of the investors over diversify or diversify their investments and hence end up committing mistakes.
The two classic examples of diversification have been discussed below: –
1) Across different asset classes
There are usually four asset classes namely equity, debt, gold and real estate. As we have already discussed that asset allocation is the key to success while investing. An investor should not choose an asset class based on a single factor. There are many other factors which an investor should look for before investing like liquidity, underlying risk and returns. Fulfilment of only one factor should not convince an investor to invest in that particular asset class. For example, investment in real estate scores very low in liquidity as you cannot sell your property in a day or two. Hence, one should not invest in real estate just for the sake of earning returns, unless and until you have maintained proper liquidity for yourself.
Another important thing one should look at is whether you would be able to stomach the underlying risk of that particular asset class or not. For example, equity mutual funds can generate superior returns over a period of time however in the short term they might be risky. So, a person in the retirement period should avoid investing heavily into equity mutual funds because it may pose the capital of the retired person at risk. Hence, an investor should avoid taking unnecessary risk and should only follow a suitable strategy.
2) Within the same asset class
Even after choosing the percentage to be allocated towards a particular asset class let’s say towards equity, investors often end up over-diversifying their assets. Let me explain this with the help of an example, if you look at the portfolio of a particular mutual fund scheme then you will find that each and every mutual fund scheme holds at least 15-20 securities in its portfolio. So now if an investor is investing in large-cap schemes and holds 3 large cap mutual funds in his/her portfolio then the investor is unknowingly just over-diversifying as these three mutual funds might be holding same stocks in their portfolios since these all belong to the same category (large-cap funds). Hence, holding many funds in the same category is not a diversification but just diversification.
Though the right asset allocation is the only thing that matters but in the desire of achieving the right asset allocation one should not forget considering other important factors. Remember the right assets held in the right amount at the right time will lead an investor towards the right path and helps in accomplishing all the aspirations of the investor effectively.