Diversification is a buzzword that continuously pops up in a investors’ mind to limit the exposure of risk within the investment portfolio. In theory, the idea appears simple — you spread your capital over a wide variety of asset classes so that you can keep away from taking a bath when the market declines. Ideally, it is a strategy to limit risk and mitigate losses on investment returns. But, it is not wise to take it lightly! Because if you are not careful while diversifying your portfolio you could lose big in spreading your capital into multiple asset classes. Here, we’ve mentioned some key reasons why many investors go for diversification but end up making it worse.
Below we’ve mentioned the reasons behind the failure in a portfolio diversification strategy. Hope, this would shed some light over the whole concept of diversification and what you should be aware of while doing it.
Don’t fully understand “Portfolio Diversification”
The purpose of investing is to see the growth in the invested capital period. As a result, many investors do the mistake of invested heavily on growth-based investment instruments. That becomes the reason for the failure of their diversification strategy. Many young investors tend to be aggressive and see doing the mistake of diversifying their portfolio by allocating their investments through different sectors only. The portfolio may be adequately diversified amongst large-, mid-, and small-cap stocks but the problem this, you’re diversified only within stocks. The true diversification can only be achieved when you invest in other asset-class to counter the risk of decline in your equity investments.
Get Emotional at the Time of Investing
Emotions have always played a key role in stock investing. It is something that can overwhelm the mind of many savvy investors and make them make wrong investing decisions at crucial times. For instance, when the stock tends to rise in value, we tempted to buy them to make part of our investment portfolio. At the opposite end of the spectrum, if the stock is not performing for a while, or bear has marker under its grip, we become overly cautious and start investing in fixed income assets or other asset class.
The actual reason behind these decisions is the emotion which overwhelms our intentions and sometimes creates an imbalance in our initial asset allocation.
Entirely Avoid Certain Asset Classes
As we mentioned earlier that investors often make the mistake of investing heavily in growth-related instruments like stocks and avoid certain asset-classes that could benefit in diversifying a portfolio. It is important to have a proper allocation between equity and debt (bonds and fixed income assets) instruments.
For instance, gold investing is a way to counter the risk of equity investments as in certain markets, the gold can outperform other asset classes. But, only if you consider other asset classes, you cannot miss out such opportunities.
Investments Don’t Follow the Market
The purpose of diversification strategy is to ensure that we are properly diversified so that our investments will rise or at least not hit hard by the market volatility. But, that is the theoretical point of view of seeing things. There are some certain market situations when all asset-classes fall at the same time irrelevant of equity or debt instrument. There are times even when the substantial position in fixed-assets results in an overall loss.
Economic slowdown due to a steep fall in the market could drop all asset-classes simultaneously. The coronavirus pandemic is one such example when the bears have tightly gripped the market by the neck. As a result, the benchmark indices have fallen over 30 per cent from its lifetime high. This lead to a fall in other asset-class like gold, silver, and bonds simultaneously.
It is very crucial to move carefully in such circumstances as any misstep could lead to significant losses that would be hard to incur for a medium investor.
Too Many Investments or Over-diversification
Diversifying investment portfolio is a good strategy to spread risk across multiple investment classes so that in adverse situations, your one or two investments won’t affect your overall portfolio returns. However, in doing so many investors fall into the trap of over-diversification. Perhaps trying too hard to minimize risk but diversifying in too many investments can hurt your potential gains in the long-term. It is recommendable to not exceed your investments above 20. On top of that investing in multiple asset classes would also increase in transaction costs which could mitigate your returns and ultimately defeat the whole purpose of diversifying.