If you spread your investments and get exposure to many asset classes, then that is called diversification.
Asset allocation is the process of allocating your money to different investments. And they offer tremendous advantages, says Rishi Piparaiya
Since childhood, a close friend had wanted to join the civil services. He was intelligent, well-read, and focused, and immediately upon completing his undergraduate studies, he took time off to prepare for the IAS exams. And he studied day and night, attended classes, and did whatever he could to prepare.
Every year, he would attempt the exam but, unfortunately, could not clear some stage and would get back to his preparations with an even greater vengeance.
This went on for many years until he exhausted all the available attempts. By then, he was in his early thirties, with no other tangible skill or work experience, and with IAS no longer an option, he had to start all over again from scratch.
Things might have been different had he not put all his eggs in this civil services basket -- while studying, he could have done a part-time job or freelancing assignments and gained some exposure to the corporate world. These could have served as backup option if the IAS dream did not work out.
Unfortunately, he had not, and he had to figure things out.
Whether in life or finances, you mustn't rely on any one initiative, one individual, or one investment for success. That creates tremendous pressure, and the consequences of something going wrong can be brutal.
Diversification -- spreading your energies, attention or money across various options -- is essential. And all the more so when it comes to your investments.
You have many options to invest your money: Fixed deposits, equities, debt, real estate, gold and so on. You could take the eggs in one basket approach and go all in into one of them, let's say, spend all your money on buying shares. If the economy does well, so will equities, and you will create wealth. However, if markets crash, so will your investment.
Or you could spread your investments and get exposure to many or all these asset classes. That is called diversification. Asset allocation is the process of allocating to different investments. And they offer tremendous advantages.
A More Stable Portfolio
Different investments react differently to the economic environment. Therefore, diversification reduces risk and makes your portfolio more stable. So, for example, if there is a recession, equity markets will crash.
But gold has historically done well in uncertain times, and if you have allocated some part of your wealth to this asset, this investment will grow.
In a collective sense, you will still be better off than you would have been if you were only focused on equities. Your portfolio will be more stable and less volatile if diversified.
Better Risk-Reward Outcome
As per modern portfolio theory, it has been determined that adding more investments reduces the expected risk instead of increasing it up to a certain point. So, a mutual fund with 20 to 30 stocks would be less risky than a concentrated portfolio of just a few stocks.
It is important to note that these strategies do not eliminate risk. Also, these are dynamic strategies, and one should regularly review one’s portfolio to ensure it remains aligned with one's objectives and risk profiles.
Peace Of Mind
Finally, diversification gives you peace of mind. A diversified portfolio is more aligned with one's risk profile and reduces the stress of market ups and downs.
If all your eggs are in one basket, all your attention will always be focused there. If they are spread across multiple baskets, you will be a lot more relaxed and be able to enjoy the other aspects of life.
Because at the end of the day, life is more than monitoring eggs and baskets; it is about enjoying the kitchen, garden and everything else! And a strong diversification and asset allocation strategy will allow you to do just that.
Rishi Piparaiya is the author of Three Pigs To Financial Freedom, Cities Of Adventure, Job Be Damned and Aisle Be Damned.
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