Old McDonald had a farm. And in that farm, he had a hundred hens. When the hens laid eggs, old McDonald gathered them in a basket and merrily started his journey to the market. Old McDonald had high hopes of making big bucks that day. The road went downhill. Old McDonald lost his balance. The poor old fellow, like Jack and Jill, went rolling and tumbling down the hill. Alas! Not only was he badly hurt, but all the eggs were gone for good. Old McDonald cried and cried and cried, but nothing could bring him back those spoiled eggs. He couldn’t recover from the loss! Hence, the adage – “Never put all your eggs in one basket.”
Now, imagine that you are old McDonald, the eggs are all your hard-earned money. Let’s say, just like old McDonald, you decide to put all your savings in a single financial instrument. What would happen if something went wrong and all your money was gone? Unfathomable, right? The very thought of such a scenario sends a chill down my spine.
Well, there’s a simple and easy solution: Diversify your investments!
What Does Diversification Mean?
The concept of not putting all your eggs in one basket largely applies to money management. Diversification essentially implies that we should allocate our investment money strategically among different types of assets and asset categories. If money were eggs, then divide the eggs into several baskets. In case something goes wrong with one basket, the eggs in the other baskets remain safe.
A basic principle of investing is to ensure a diversified portfolio. The idea is to spread the capital amongst different investments so that investors aren’t reliant upon a single investment for all of their returns. Diversification helps minimize the risk of capital loss to an investment portfolio.
Minimize risks of loss – if one of your investments doesn’t perform well over a certain period, your other investments may perform better during that time. It significantly reduces the potential losses of your entire investment portfolio. Had you been concentrating all your capital under one type of investment, your finances might have gone for a toss.
Generate returns – investments might not always perform as expected. Let’s say you put your entire corpus into a single mutual fund that’s been constantly performing well; you rely upon this single investment to be the source of a bountiful return. What if the fund fails to perform well? By diversifying your investments, you’re not merely relying upon a single source of income or return.
Preserve capital – not all investors are accumulating wealth; those who are close to retirement are more focused on the preservation of capital. Diversification helps protect the savings that you’ve accumulated over the years.
What Defines a Diversified Portfolio?
If you intend to diversify your investment portfolio, you must focus on reducing your overall investment risk by spreading your corpus across different asset classes. You need the right mix of defensive and growth assets.
Investments such as cash or fixed interest deposits qualify as defensive assets. Such investments provide a lower return over the long term. However, they also come with a low level of volatility and risk.
Investments such as shares or property that generally provide more capital gains over a longer term are called growth assets. Although these investments are lucrative, they typically have a high level of risk since the return on such investments is largely dependent on market fluctuations.
How to Diversify Your Investments?
- To build a diversified portfolio, you should aim to spread the investment risk across different asset classes. Keep some of your funds in fixed income investments (like bank FDs, PPF, debt funds), some in the share market, and some in properties.
- Within each of these asset classes, diversify your money even further. For instance, if you’re purchasing shares, then do so across different industry sectors.
- If you’re investing in managed funds, make sure to spread it across different fund managers.
No investment can consistently outperform other investments. Different types of investment perform in different ways owing to a range of factors like:
- current market conditions
- interest rates
- currency markets.
For instance, your share portfolio may suffer losses during periods of increased share market volatility. If you simultaneously hold investments in other asset classes, such investments may perform better during the same period. Moreover, the returns from safe and steadily growing investments like Fixed Deposits, Post Office Monthly Income Schemes, Public Provident Fund, etc. can help mitigate the losses. Thus, diversified investments can keep the returns of your overall investment portfolio smooth and steady.
To Sum up
No investment is absolutely safe. However, diversifying your investments can fetch you a smoother and more consistent return in the long run. Think twice before making an investment decision. Research adequately before signing up your hard-earned money for anything.
Learn a lesson from old McDonald and invest wisely.