Why diversification of assets is important
When it comes to investing, you have probably heard the age old adage, “don’t put all your eggs in one basket.” You probably are tired of listening this many times. But it actually is very important when it comes to protecting your wealth and assets from unncessary risk.
Diversification of assets means that one does not invest all his money in the same asset class or in the same industry in the case of equity shares. So lets say, you have a $5,00,000 with you and you decide to invest it. In order to diversify you buy real estate worth 30% of that amount, which would be $1,50,000. Now you have $3,50,000 left. Out of that you decide to invest $1,50,000 in equity shares, $1,50,000 in bonds, $40,000 in gold and the remaining $10,000 in cryptocurrency. Well, you just diversified your portfolio and now you don’t have to bear excess risk of losing your wealth.
The basic idea is that you should divide your money and invest it in different asset classes or sectors in case of equity market, so that in case one destroys your wealth then the other may help you recover most of it or at least breakeven or even better give you profits.
Lets take the example of equity shares now. Lets say you think that the steel industry is going to do well now or maybe someone has tipped you that it would grow multiple times and give you huge returns. You decide to put all your money in buying shares of steel companies. You have purchased shares of 4 different companies but all of them from the steel industry. You see your money growing for a few days and you start feeling good about yourself or you thank the person who advised you to invest in the steel industry.
But, sadly due to some reason like maybe an economic recession or a downward trend in the steel industry (Steel industry is a cyclical industry) the steel industry comes crashing down. By the time you check your portfolio, its probably too late and maybe you have lost some money on your investment. This could have been avoided by diversification.
Lets say, an investor wants to invest in the equity markets and he knows about diversification. He would buy shares of different companies from different sectors. This way he reduces the risk of losing his money. He buys shares of companies from the steel industry, automobile industry, banks, financial institutions, technology industries, mining and maybe other industries as well. This way he has diversified his portfolio. And in case the steel industry does go down, he has investments in other companies which will help him to set off that loss.
In case of bonds (In simple terms, a bond is a promise by the company that it would pay the amount that it has borrowed along with interest after a particular period of time), its always better to buy bonds from companies which have a good credit rating. There are credit rating institutions like Moody’s, S&P, CRISIL, ICRA and others. These credit agencies analyze the financial health and capability of the companies to pay back their debt. Lets say Company A wants to raise a sum of $1,00,000 and it decides to do this by issuing bonds. So, the credit agencies here analyze the capability of Company A to pay back that amount and rate it. Company A is a really good company with great financial health, so it would get a high rating. This means that you don’t have to worry too much about not getting back your money. When a company has a higher rating it tends to pay less interest on it. That is because the investor has to bear less risk over here.
Lets take the same Company and lets say its facing some problems now. Its hard for it to payback its debt. The credit rating agencies would give it a lower rating and this means that its risky. There is a chance that the investor who buys its bonds may not be able to recover his money as the company may default on its debt. But at the same time the company will pay a higher interest on those bonds because now the investor has to face higher risk. We all know higher the risk, higher the returns. The same rule applies here.
To conclude, I would say that its always best to diversify and invest in different asset classes as this can help reduce the chances of an investor losing his money.
Thank you for reading my post. I would love to know about your opinions, suggestions and feedback in the comments below. Please do share this post.