The Importance of Investment Diversification: Why You Should Diversify | Spring Money
- Akash Yadav
- Mar 10, 2023
- 5 min read
Updated: Aug 6, 2024
When you invest your hard-earned money, what do you in general expect from it?
Well, I can answer that! “Maximum returns with minimum risks”, and it’s not just about you and me, every investor hopes for the same, but how it could be possible?
Diversifying your investment is one of the most effective ways to do so. Diversification might seem like a complicated process, but it's actually pretty much simple. In this blog, we’ll explain why diversification is so important and how it can keep our investments off the risks.

What is Diversification in Investment, and Why it’s Important?

Theoretically, diversification is a strategy that is implemented to reduce risk by splitting your investments across various areas that would react differently to the same event.
However, investment professionals agree that diversification doesn't give surety against loss but is defiantly important for a long-term investment. Let’s understand this with a real-life example.
After the lockdown declaration during the Covid-19 pandemic when the stock market crashed drastically and sectors like real estate, automobile, banking, and most fell down to almost ten times of there all-time highs, the pharma and healthcare sectors were on surge. Obviously, it’s not in our power to predict such events in advance, but the least we can do is prepare our portfolio so that it could balance our investments under such turbulence.
Hence it's of extreme importance to diversify our investments in order to bring good returns keeping us at distance from the risks. Also, the stock market is just one of the other asset classes like real estate, bonds, fixed deposits, and others.
The Risks of Not Diversifying:

The risks of not diversifying your investments are clear. If you put all of your money into a single investment or a single asset class, you're exposing yourself to significant risks. If that investment or asset class performs poorly, your entire portfolio will suffer.
For example, if you invest all of your money in a single stock, and that company experiences financial difficulties or goes bankrupt, you could lose your entire investment.
On the other hand, if you diversify your investments, you spread your risk across a variety of different investments, which reduces the impact of any one investment's performance on your overall portfolio. Even if one investment performs poorly, the others will make up for it, and your overall portfolio won't suffer as much.
How to Diversify Your Investments?
Well there are several ways to diversify your investments, including:
1. Invest in different asset classes
Diversifying your investments across different asset classes can help to reduce your risk and would bring good returns on investments. This means investing in a mix of stocks, bonds, and other securities. Look, the sole motive behind the diversification of investments is to avoid losses and in general, you always need a backup plan to watch your back during unpredictable situations. So during investing, diversification helps you in strategizing a backup plan that would prevent heavy losses.

In the above-given graph, there are two different assets, A(indicated by blue) and B(indicated by red). Now that you know their performance within a period of 10 years, which one would you choose to put your ₹100 on? Definitely, asset A will be everyone's choice. Because it's giving over 140% return in 9 years by growing ₹100 into ₹240. From the above example, let's assume that asset A is more rewarding than asset B, but is also riskier, of the two. We all know that it's not possible to judge what asset class will perform in what manner with time and to different events. Now, imagine you put ₹100 in asset A and that asset class doesn't perform or suffered a loss, your investment of ₹100 could decrease down to 60,50,40 or even to ₹10. But, diversifying your investment of ₹100 among assets A & B would give a final outcome that will not depend only on the performance of one asset class. Similar as represented in the above graph, with the green trend line, that isn't performing better than asset A alone, but neither is attracting that much risk from that class because some investment has been put in asset B. How you diversify your investments depends on factors like risk-taking ability, reward/growth expectations, and goals. Someone might allocate 30% to asset A and the rest 70% to B, while, one can invest in both equally.
Now let's see a real-life example to understand the value of diversification.

The above chart represents the performance of four different asset classes between 2013 and 2022. The chart shows the return on ₹100 investment.
Now if given a chance, in which of the above-mentioned asset would you invest your ₹100 in the year 2012? undoubtedly everyone will choose Large caps because it has given a 200% return on the invested amount. But it's not in our power to make accurate predictions for the future. Nobody would have been in the position in 2012 to tell what kind of returns a large cap will give at the end of 2022.
In the above chart, you can see that the green trendline indicates the performance of the portfolio value when the same amount is diversified among these assets. The diversified portfolio has given a return of 143% whereas the top-performing asset large-cap has given a 200% return
This diversified investment portfolio has not shown a better return than large-cap, but what's most important is, it will neither attract all risks that are associated with that asset class. If all your investments would have relied on large-cap only it could attract heavy losses when that asset class suffers.
2. Invest in different Industries
Similar to investing across different asset classes investing in different industries can help to reduce your risk.
For example, if you would have invested in the automobile and healthcare sector, your portfolio would have not suffered massive losses during the Covid-19 pandemic. Unlike someone who invested just in one industry, be it automobile or real estate.
3. Invest in mutual funds or ETFs
Mutual funds and ETFs are a great way to diversify your investments. These funds typically invest in a mix of different stocks, bonds, and other securities. Basically, it's like investing where diversification is on auto-pilot mode, and you don't have to worry about picking individual investments yourself.
4. Rebalance your portfolio regularly
Rebalancing your portfolio regularly can help to ensure that your investments are still diversified.
For example, consider that you allocated 30% amount of your investments into asset A, a few years ago. Now as suggested by your RIA(Registered Investment Advisor) or you, anticipate that chances are that this asset A will not perform as expected in coming years. In such conditions, it's better to invest some portions or the entire amount into another asset that could ensure better returns.
Apart from this, suppose you invested some amount equally in both assets A and B, but after a year, asset A has overperformed asset B, and now alone contributes 70% of the total amount. Here now the investment portfolio will get more prone to risks associated with asset A because now it's a major part of the total invested amount. Hence managing your risks to ensure the safety of your long-term goals, it's important to rebalance your portfolio and allocate the weightage of each asset as planned previously.
Conclusion
Diversification is a simple yet powerful tool for investors. By spreading risks across a variety of different investments. The biggest advantage of investment diversification is that it doesn't disrupt our mental peace more often. However, it's everyone's personal choice to plan diversification of the portfolio depending upon their reward and risk expectation.
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