Diversification is one of the most misunderstood terms in personal finance and investments. In this article, we discuss the cost of diversifying your investments. We then explain why you should diversify and suggest ways to go about it easily.

Diversification cost Diversification involves investing in multiple assets with the objective of minimising risk. So, instead of investing only in equity, you should buy some bonds and gold as well. Further, instead of buying one equity fund, you should perhaps buy a couple of such funds.

There is, however, a cost associated with such diversification. Let’s say, in one scenario, you invest in only one equity fund, and it generates an annual return of 25 per cent.

In the second scenario, you invest 50 per cent in the above fund and 50 per cent in one that generates 10 per cent return. Your total portfolio return will then work out to 17.5 per cent — 7.5 percentage points lower than in the first scenario.

Of course, only in hindsight will you know which fund performed better. What if you only invest in a fund that incurs losses? It is this uncertainty of returns that prompts you to diversify. You should be willing to sacrifice returns if that will reduce your investment anxiety and uncertainty.

How to diversify So, how should you diversify without complicating the investment process? Our suggestion below is based on the premise that you invest in equity funds, bank fixed deposits and gold.

Consider bank fixed deposits. You should choose not more than four banks to spread your investments. If you are concerned about the risks related to private banks, then spread your deposits equally between public and private sector banks.

Investing in financial gold is easy. You should buy only one gold ETF; all gold ETFs have the same underlying gold investment with the same returns.

Your choice of equity funds can be somewhat complicated. So, you should first decide whether you want to buy index funds or active funds. If you choose index funds, you do not have to diversify; all index funds on the same benchmark index carry similar risk and return.

On the other hand, if you choose active funds, then invest in not more than three funds. Buy an active fund only if you are confident that, one, the fund manager can beat the appropriate benchmark index and, two, you can correctly identify such a fund manager. In a nutshell, it is best to keep your investment process simple. So, think of diversification as a means of reducing your emotional stress, not minimising losses.

Lured by choices Diversify your investments by spreading your capital across equities, bonds and commodities. Do not attempt to spread your equity investments across many funds, or your fixed deposit investments across several banks.

You will diversify when faced with choices. Diversifying simply because you have an array of choices will only lead to a cluttered portfolio with no significant benefit.

Diversification is not about how many assets you have. Rather, it is about how they are related to each other, a relationship that changes with the market.

The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

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