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6 type of Portfolio Diversification – Meaning & Strategies

by Manish Chauhan · 31 comments

A lot of people with high networth still do not understand Portfolio Diversification. They made good money, their investments have zoomed over the years and they feel that they have understood the mantra for growing wealth. However an important parameter to look at is “Diversification” . How much diversified you are in your overall financial life ? Let us understand what strategies we can adopt for diversification of portfolio, but lets look at 2 examples to understand the problem first.

Example 1

Lets look at Ajay’s example – whose net-worth has is 4 crore overall, but 3.5 crores is in just one flat in Mumbai. What can go wrong ? There can be several events which can effect Ajay , An earth quake in Mumbai can come someday, prices may suddenly take a hit (if not today, may be in future, Ajay might come to know someday that the quality of material used is not good, Liquidity issues etc etc

Example 2 

Robert has successfully grown his net-worth to Rs 15 lacs in just 3 yrs, but the issue is that most of this 15 lacs in concentrated into a single mutual fund called HDFC Top 200 . What can go wrong ? – The equity markets can see one of the biggest fall just 3 years before Robert needs the money, The stocks picked by the funds can do exceptionally bad, the fund manager might take wrong decisions in a row, The expense ratio increases and you don’t know its hurting you badly from many years etc etc.

While these are hypothetical examples, you must have got a good idea of what I want to say here. A portfolio extremely skewed on one side can be extremely dangerous , may be the chances of risk is low, but still it can occur ! .

Diversification in Personal Finance

6 types of Portfolio Diversification

Asset allocation is a word which describes how well are your assets allocated across various asset classes and you do it with diversification ! . A lot of people feels that just because they have invested in 10 mutual funds , they have diversified their investments, but portfolio diversification is achieved at different levels. In my book Jagoinvestor, In the last chapter I talk about simplicity of Financial life and show how 3 mutual funds are not too much different than 5 mutual funds in equity diversified category , Their underlying investments (large cap stocks, mid cap, concentration of the largest stock) are pretty much exactly same. Now Lets see some of the types of Portfolio Diversification

1. Across Asset Class

You might want to diversify your investments in different asset classes like equity (mutual funds, stocks) , Real estate , Debt products, commodities like gold, silver and finally Cash. Its important to do this kind of diversification if you are not an expert in one asset class and can not handle it fully.

2. Within Asset Class

When you invest your money in one asset class but in different kind of instrument or company , you are diversifying it across various instruments of same types. A very simple example is opening Fixed Deposits in various banks. If you had to open a 10 lacs FD , the chances are you will choose 4 banks and put 2.5 lacs in each rather than doing it for 10 lacs in just one bank. In the same way some one investing in 5 different equity mutual funds. While the underlying asset class is exactly same (equities) , but still some kind of diversification is there (different fund managers handling it).

3. Geography Wise

Then you can diversify location wise or geography wise. You can invest in real estate in India, US , UK .. You can also invest in real estate across different cities within India . You can buy stocks in Indian stock market, US stock markets and other countries too. The idea is to take advantage of currencies fluctuations too, but this is only for experts who understand that.

4. Across Capitalization

When you invest in mutual funds, you can choose to invest in small cap funds, large cap funds, extra large cap funds, small companies , big companies, etc etc. Note that the risk and return potential will be different and anyways you will invest in different companies.

5. Across Time

Your investments can be across time also, like long term investments, short term investments, medium term investments , You can have a 5 yrs deposit, 2 yrs deposit and 6 months deposit as well . Imagine if you have done 5 yrs deposits only – which can affect your liquidity

6. Across Style

There can be diversification across styles – You can invest in products giving you fixed income, or which are just for growth purpose. You can invest in some thing which has value investing principles or more of speculative idea’s .

Can you think about more kind of diversification or any other benefits for portfolio diversification ?

What about Over diversification ?

Should you diversify in all ways ? Definitely not . The above idea’s are just to show you how many kind of diversification’s can be there, you should not over do it and try to incorporate all kind of diversification’s in your financial portfolio. Just see how much makes sense in your case and properly access how much you need it .

If you look at your current portfolio, Much many marks out of 10 will you give on the parameter of “Portfolio Diversification” or “Asset Allocation” ?

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{ 31 comments… read them below or add one }

1 Swetank Saroj August 24, 2012 at 10:41 am

Hi Manish,

A nice article. I believe most of the netizens, especially who invest in MF or stocks know about portfolio diversification. But the biggest problem is to know the optimum ratio and where to invest.

You have already raised a few very valid points like the quality of construction and exposure just to one MF. I believe the best route to overcome this difficulty is to get frequent feeds from a good advisor (hard to find). But again as already citied by many, if one is paying a fee on a yearly basis, the return should have to be able to compensate that. I agree that it is not always possible and also the fee need to be linked to the annual invested amount with a cap on min and max fee.

Now if I take my own example, I never understand the direct equity. Whatever stock I have invested in is in loss except I have made money only in IFCI and mostly able to get back my annual DMAT charges via NIFTY ETF.

Most or say all of my equity investments are through MF and ULIPS and the debt part being taken care by PPF and EPF. I always feel and know that I need to move my MF from some of the bad funds to good funds but again as mentioned earlier; the advisor will charge and the returns should match that charge.

Thanks,
Swetank

Reply

2 Manish Chauhan August 26, 2012 at 12:40 pm

Swetank

I dont think we should look at that perfect ratio, because if you deviate from the perfect ratio, the resultant affect will not be very bad or different ! ..

Reply

3 Nitin August 24, 2012 at 11:26 pm

Hi Manish,

Nice article. Lot of unanswered questions but I think those have to be answered by individual(us) depending on our taste, risk ability, income, future income, wealth, liabilites and many more.
I have my investments in MF(balanced, mid, large), ULIP(small portion) , Gold and FD’s. I want to venture in infrastructure but that’s very costly avenue and even if I do it, it’ll suddenly become very skewed as infrastructure most of the time is good chunk of investment. Point is that we should look at other asset class or investment avenue when our current diversification starts to become heavy in one particular area (say MF, ulip etc as in end it’s all equity). Affordability, price and fees(international market) needs to be considered as well.
What do you think on how much minimum diversification any mid-income person (where most of us belong) should have and which categories?

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4 Sanjay August 25, 2012 at 11:57 pm

Very apt question.
Same thing is about real estate. Real estate is also asset class which takes a lot of investment. If one has to go for diversification then he can not invest in real estate for first 10 earning years of his life. He might be sure that real estate prices have hit rock bottom (because of credit crisis or high interest rates or whatever) but he cannot do it because of rule of diversification.
I think everybody has to also think for tactical allocation for short term. Diversification can be a long term goal which can be achieved by rebalancing.

Reply

5 Manish Chauhan August 26, 2012 at 12:15 pm

Nitin

Starting point can be debt and equity instruments and in some year, it can be real estate ..

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6 Manyam August 25, 2012 at 8:30 am

Good information. Could you also share if any technically studies or suggested ratios of each diversification type? (Like How much for equity / debt / commodities / real estate / cash in hand).

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7 Manish Chauhan August 26, 2012 at 12:11 pm

It will be too much complicated and overkilling .. Just diversify in each of them based on your understanding and the internal feeling which says , its good enough ! and you are comfortable !

Reply

8 VIVEK KUMAR August 25, 2012 at 10:21 am

VERY INFORMATIVE AND NICE ARTICLE

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9 IsItPossible August 25, 2012 at 7:26 pm

Good but generic article, would have liked to see some real world examples of portfolio diversification.

For those looking for some ideas:
Approach:
If you have “X” amount to invest then use a simple formula along with some basic ideas.

Answers you should know before investing in any asset-
1. Your time horizon for that specific investment
2. Up to what amount of losses are you willing to take! at which point you will close that position!!!
3. Your approximate target price

If investing in stocks:
No more than 20% in any one company stock

If investing in Mutual Fund:
No more than 3-5 mutual funds in your portfolio

Capital preservation MUST be TOP priority along with good risk/reward management…

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10 Manish Chauhan August 26, 2012 at 12:00 pm

Yes it was written with the basic content intent only.

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11 Maulik Rachh August 25, 2012 at 10:49 pm

Hi Manish,

It is a good article..i just want to share one thing.I observe that many people have interest in gossips and all.They just wanna to have fun.But about the financial planing and literacy, I think still we have lack of interest.When world economy is performing poor now a days, Financial planning becomes an imp area for us.From jagoinvestor, I really gets a much knowledge and i am able to implement it also as i am a finance professional.Thanks for the article

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12 Manish Chauhan August 26, 2012 at 11:59 am

Thakns for your appreciation !

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13 kulbhushan August 26, 2012 at 7:07 pm

helpful but I expected more informative article from Jagoinvester. Never the less, it is because of Jagoinvester that we get to know so much in regards to financial sphere…

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14 Manish Chauhan August 29, 2012 at 10:43 am

This was meant to be a basic one .. there are more articles written earlier on the subject , please find them and read them

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15 kulbhushan August 29, 2012 at 3:55 pm

I have read all your wonderful articles sir.

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16 Abhinav Gulechha August 28, 2012 at 11:30 am

Hi Manish

You have picked up a very pertinent topic and its very relevant especially where equity market is in a prolonged bull phase or bear phase (as its doing now!)

I just remember a quote by a financial planner in Deena Katz book – “We shall design awfully boring portfolio for you (one that is diversified across asset classes) but it will ensure you sleep peacefully at night”

However, if we dig deeper at an individual portfolio level, some challenges in portfolio diversification are as follows:

• There cannot be one fits all allocation ratio between asset classes (it depends on age, family situation and risk appetite of the person)
• Even if one invests according to allocation ratio, he/she should be aware that periodic rebalancing (i.e. moving from one class to another) is required to get full benefit from asset allocation.

I would appreciate if you can cover these finer issues and your views on the same, in one of your next posts.

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17 Manish Chauhan August 28, 2012 at 9:48 pm
18 Ashish Sapre August 28, 2012 at 2:50 pm

Hi Manish,

I am reading your articles since last 6 months or so and I must say I am becoming enlightened and addict. Whenever I need any financial guidance I first check some related article on this site. Keep up the good work.

Just one point to make. Please print the date of posting on the top of post. Its hard to know if the article is still valid when I come to your site through googling. Once I read a full article about ICICIdirect charges and only through comments I came to know that its 3 year old and those rates might not hold valid. (Please correct me if I am missing article dates.)

Wising you success in waking up investors. :)

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19 Manish Chauhan August 28, 2012 at 9:33 pm

Ashish

Thanks for your suggestion , I have removed them for other reasons. But even if date is not mentioned, you can look at the url and see the year and month number, that way you can see if its old or new !

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20 suresh August 28, 2012 at 7:39 pm

I liked the point about diversification of investments with asset class. We can try for maximising the returns thru this. Thanks.

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21 Manish Chauhan August 28, 2012 at 8:19 pm

Suresh

Thanks for your comment . But I thought diversification by asset class is the first level of diversification that should come to the mind by logic, Isin;t ?

Manish

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22 Abhinav Gulechha August 29, 2012 at 9:57 pm

Thanks Manish for the link. I had a look and it was a bit lengthy so will spend some dedicated time to read it. Your posts and the discussions that follow is superb learning for me. Thanks.

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23 Rahul Srivastava October 10, 2012 at 4:45 pm

Hi Manish,

I am 30, IT Professional (only breadwinner in family), married since 5 years (& have a daughter of 2.5 years).
I have a LIC Moneyback Policy since last 6 years for which a pay a premium of INR 18000 annually & it pays me back INR 50000 every 4 years. Also, I started a ULIP Child Plan (ICICI Smart Kid) last year, where I pay INR 25000 annually for a SA of INR 5 lakhs. These 2 policies, 1 Term Insurance Plan (from ICICI), 1 Mediclaim Plan & 1 ELSS constitute my tax planning.
I am going to dis-continue the LIC Moneyback Policy, immediately & might re-consider dis-continuing the ULIP Child Plan as well. I believe, one should never fall in trap of low-yielding policies such as Moneyback, Pension, Endowment, ULIP etc. at least, at my current stage. I already have monthly SIP worth INR 21000 in 6 Equity mutual funds.
Could you please suggest where should I channel this INR 18000 annually (+ INR 25000, probably)? My goals are house (2 years from now), daughter’s study & marriage, pension(25 years from now) & a significant health corpus. I dont have any loans/debts etc.
Your suggestions regarding best possible avenues for investment of INR 18000 annually (+ INR 25000, probably), would be highly appreciated.

Regards,
Rahul

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24 Manish Chauhan October 12, 2012 at 12:13 pm

Rahul

I think you can get one more 50,000 payment and then stop this money back plan , its just 2 more years you need to pay to get 50k , also you should better invest in equity mutual funds for long term goals, You can use our goal calculator for planning for these goals .

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25 Rahul Srivastava October 15, 2012 at 12:04 pm

Thank you for the tip, Manish.

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26 Rahul Srivastava October 15, 2012 at 2:33 pm

Hi Manish,

This is Rahul Srivastava again:-) Could you please comment on & suggest/modify my MF portfolio below ( started Dec2011 ) ? Any advice from your side would be highly appreciated.

Fund Category Monthly Allocation
ICICI Pru Focussed Bluechip Equity Fund Large Cap 3000
ICICI Pru Discovery Fund Midcap & Small cap 3000
IDFC Premier Equity – A (G) Midcap & Small cap 3000
SBI Magnum Emerging Busi (G) Midcap & Small cap 5000
UTI MNC Fund (G) Diversified Equity 2000
Reliance Gold Savings Fund (G) Gold 2000
SBI Magnum FMCG Fund (G) Sectoral-FMCG 3000

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27 Manish Chauhan October 16, 2012 at 1:57 pm

1st and 3rd look good to me .

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28 Rahul October 31, 2012 at 11:02 am

Hi Manish,

Could you please help me in identifying a Debt/Hybrid product that would suit me for a SIP worth INR 2000 monthly ?
My requirements are:
1) Low Taxation
2) Safe Instrument (so Pure equity is totally ruled out)
3) Returns over 9% (because one can easily get 9% when doing FD in spouse name, provided she does not have a regular income/job).
4) Some degree of Liquidity should be there (can compromise on this aspect)
5) Matures within next 3 years (this is must-have)

I am unable to choose between the vast categories of Debt funds: GILT, Income, Bond, Dynamic Bond, Balanced Equity Fund/Gold Savings Fund etc. So, more than the fund/ fund house itself, I would like to understand which categories of investment would suit my need from the different types of Debt/Hybrid Fund. By the way, my financial adviser is insisting on a Gold Savings Fund; he has always been too bullish on gold, while I am not too sure about Gold volatility in 3 yrs term. The second option he has suggested me is a balanced Fund from HDFC stable (HDFC Children Gift, HDFC Balanced or Prudence Fund). He says that no income or Debt fund can provide returns equaling Gold or Balanced fund in this time-frame. I doubt this. I am more inclined towards GILT fund like-Kotak, IDFC, BSL etc.
Hope I have made my requirement clear. Thanks in advance.

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29 Manish Chauhan November 2, 2012 at 11:33 am

I can just think of FMP’s or a debt fund in your case. Do not over think in the best plan , as debt funds returns are anyways less volatile .

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30 Ramana March 16, 2014 at 11:39 am

Dear Manish,
I have a query. I have a demat account which also is linked to trading account – I have put in place a kind of SIP for direct purchase of equity every month. But in emergencies, I noticed that I disinvest and replenish later but am wasting in terms of repurchase, etc.
I want to put part of my equity holdings in a demat which does not have any trading account linkage and hence I have to look for alternatives for fund mobilisation or face the liquidity crunch somehow. My wife has a demat account like that. So how can I transfer from my demat to her demat – with minimum fuss and charges.
Regards
Ramana

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31 Manish Chauhan March 26, 2014 at 7:28 pm

Hi Ramana

This can be very specific to the bank you have account with , can you also mention the bank name and ask the same query on our forum – http://www.jagoinvestor.com/forum

Reply

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