Before you start investing, understanding the basics is important. You invest your money to build wealth, achieve financial stability and independence, and meet various goals over your lifetime.
Diversification is a strategy that is beneficial in lowering the investment risk and maximizing returns. You must choose different financial instruments to invest your funds.
The best investment mix is based on your personal goals and requirements. Here are two factors you must consider while determining the asset allocation.
1. Risk Tolerance
All investments have certain inherent risks. For example, equities have the risk of adverse market movements, real estate is very volatile, and even deposits face the possibility of defaults. Risk tolerance is your willingness and ability to lose some or all of your capital investment. You must assess how much risk you want to assume to determine your asset allocation.
2. Time Horizon
This is the maximum period for which you are willing to hold your investments. If you have a long-term investment horizon, you may be willing to assume higher risk to earn more returns. This is because you are able to hold your investments through the different market cycles. On the other hand, if you have a financial goal in the short-term, you may opt for safer products like bonds.
Here are three reasons that make diversification of your investment portfolio important:
1. Reduce Risk
Different financial products have disparate movements to certain events. For example, a particular market condition may result in an increase in the price of one asset class while another may see a price reduction. When you diversify among different products, the risk of adverse movement is reduced and you can balance the returns on your investments.
2. Opportunity Cost
Different asset classes offer various opportunities to earn higher returns. If you invest all your funds in a single product category, you may be unable to take advantage of favorable movements in another instrument. Diversification ensures you do not lose on any opportunity to earn higher returns.
3.Liquidity
You may invest in a single product like company deposits and a situation may arise where suddenly require some funds. Due to the nature of your investment, you may not be able to liquidate the capital you have invested and may have to forego some or all of the possible returns due to premature withdrawal of your capital. This is avoidable when you diversify the total available funds among different asset classes.
Your portfolio diversification should keep getting updated. Any change in your financial situation or goals will require reallocation. If your risk tolerance and time horizon change, you will need to make the required modifications to your portfolio.
Asset allocation is important for earning good returns on your investment portfolio. However, it is subjective and varies from one person to another and changes over a period of time. Therefore, it is crucial that you periodically review, diversify it across investments in equity, derivatives, SIPs, Mutual Funds and modify your asset allocation in order to maximize the benefits.