16-Jan-2023
2 mins read
Diversification is a risk management strategy that spreads investments across different asset classes, sectors, and geographical regions. During periods of market volatility, diversifying one’s portfolio can reduce the effect of any losses in one area, as the positive performance of other investments can help to offset those losses. This can lower overall portfolio risk and improve the chances of achieving long-term investment goals. However, it’s important to note that diversification does not guarantee a profit or protect against loss.
What is Market Volatility?
Market volatility refers to the level of fluctuation in the prices of securities or assets. It is a measure of how much the value of an investment can change over time. When there is high market volatility, the prices of securities or assets can fluctuate dramatically in a short period. This can make it difficult for investors to predict the future value of their investments and can lead to increased risk.
Many factors can contribute to market volatility, including economic conditions, political events, and changes in investor sentiment. Market volatility can be caused by both positive and negative news, such as a positive economic report or a natural disaster.
When there is high market volatility, it can be challenging for investors to make sound investment decisions. It can also lead to increased stress and uncertainty for investors. However, some investors may see high market volatility as an opportunity to buy assets at a lower price or to take advantage of short-term market fluctuations.
It’s important to note that market volatility is a normal part of investing, and it’s important to have a well-diversified portfolio and a long-term investment strategy in place to manage the risk.
Correlation
In investing, correlation refers to the relationship between two or more assets or securities.
A positive correlation means that the two assets or securities tend to move in the same direction. For example, if one stock goes up, the other stock is likely to go up as well. A negative correlation means that the two assets or securities tend to move in opposite directions. For example, if one stock goes up, the other stock is likely to go down.
How does correlation apply to Investment Diversification?
Correlation refers to the relationship between two assets or investment returns.
When it comes to investment diversification, the goal is to include a mix of assets with low or negative correlation. This means that when one asset performs poorly, the other assets in the portfolio are more likely to perform well. This can reduce overall portfolio risk and improve the chances of achieving long-term investment goals.
For example, if you have a portfolio that consists mostly of stocks, adding bonds can help diversify the portfolio and reduce the overall risk. Stocks and bonds often have a low correlation, which means that they tend to move in opposite directions during market downturns. Bonds often perform well when stocks are performing poorly, and vice versa.
It’s important to note that correlation can change over time and is not always constant. It’s important to regularly monitor the correlation of assets in your portfolio and make arrangements as needed.
Tips for Portfolio Diversification during Market Volatility
Avoid Investing a Lump Sum Amount
It is generally advised to avoid investing a lump sum amount during market volatility as it can be risky. When the market is volatile, prices can fluctuate rapidly, making it difficult to predict which way they will go. Investing a large amount all at once during these conditions can increase the chances of incurring significant losses. Instead, it is often recommended to consider rupee-cost averaging, which involves investing a fixed amount at regular gaps over a period of time. This can help to reduce the impact of market volatility on an investment portfolio.
Invest in Mutual Funds via SIP
Investing in mutual funds via Systematic Investment Plans (SIPs) can be a great way to diversify your portfolio during market volatility. Mutual funds as a diversified investment vehicle can help spread risk across a range of assets, such as stocks, bonds, and cash, which can help to mitigate the impact of market fluctuations on your portfolio.
SIPs allow investors to invest a fixed amount at regular intervals, typically monthly, into a mutual fund, regardless of the current market conditions. This approach also known as rupee-cost averaging, can help to lower the effect of market volatility on an investment portfolio. An investor can purchase more units when the price is low, and fewer units when the price is high by investing a fixed amount at regular intervals, which can potentially lead to better returns over time.
Invest in Equities for a Longer Horizon
Investing in equities for a longer horizon can be an important aspect of diversification during market volatility. Equities can provide the potential for higher returns over the long term, but they also come with a higher level of risk. By investing in equities for a longer horizon, an investor can potentially ride out short-term market fluctuations and focus on the longer-term growth potential of the stock. Equities as a class tend to have higher returns than bonds, cash, or real estate over a long period of time and are considered a good source of long-term growth.
Different ways of Portfolio Diversification
There are several ways to diversify investments:
Equity Funds Diversified Across Geographies: Investing in equity funds that are diversified across different regions or countries can reduce the effect of any downturn in a specific market. Different economies and markets may be affected differently by global events, company-specific news, and economic conditions. By investing in a range of countries, investors can gain exposure to a mix of companies with varying levels of risk and growth potential.
For example, investing in an equity fund diversified across the US, Europe, and Asia can help reduce the impact of any downturns in a specific region or country. Similarly, investing in a fund with a mix of developed and emerging markets can also provide diversification benefits by offering returns that are not closely tied to a specific market.
Equity Funds Diversified Across Various Market Sectors:
Investing in equity funds that are diversified across different sectors can reduce the impact of any downturns in a specific sector. Different sectors may be affected differently by global events, company-specific news, and economic conditions. By investing in a range of sectors, investors can gain exposure to a mix of companies with varying levels of risk and growth potential.
For example, investing in an equity fund that is diversified across sectors such as technology, healthcare, energy, and consumer goods can reduce the impact of any downturn in a specific sector. Similarly, investing in a fund with a mix of growth and value sectors can also provide diversification benefits by offering returns that are not closely tied to a specific sector.
Diversify Debt Investments
Diversifying debt investments is a way to spread the risk across different types of bonds and borrowers. It can reduce the impact of any losses in one area as the positive performance of other investments can help to offset those losses.
Here are a few ways to diversify debt investments:
Credit Risk Diversification: Invest in a mix of bonds with different credit ratings, such as AAA-rated bonds, AA-rated bonds, and A-rated bonds. This helps spread the risk across different borrowers, as bonds with lower credit ratings are considered riskier than bonds with higher credit ratings.
Maturity Diversification: Invest in a mix of bonds with different maturities, such as short-term, intermediate-term, and long-term bonds. This helps spread the risk across different timeframes and provides a steady income stream.
Sector Diversification: Invest in a mix of bonds issued by different sectors, such as government bonds, corporate bonds, and municipal bonds. This helps spread the risk across different sectors and provides a steady income stream.
Currency Diversification: Invest in bonds issued in different currencies; this can help to spread the risk across different currencies and can also provide a steady stream of income.