Risk Diversification

Diversifying investments across asset classes and sub asset classes, and at the level of securities is an efficient way of managing risks in a portfolio. All asset classes: equity, debt and others, do not perform the same way over each period. Depending upon the prevailing economic conditions the performance of different asset classes vary. Inflationary conditions favour gold but is negative for debt and equity investments, most asset classes respond positively to momentum in the economy and low interest rates. Even within asset classes the sub-categories respond differently.

For example, short term debt instruments earn higher coupon income when interest rates go up, but long term debt securities take a hit on total returns as the values of long-term debt securities fall in a scenario of rising interest rates. Understanding the nuances of changes in economic conditions and rebalancing the portfolios accordingly is essential to make sure that the portfolio has assets that balance out losses in one or the other. If a portfolio is not effectively diversified, a fall in one asset or investment category will see a steep fall in its value.

It is difficult for investors to build and maintain an effectively diversified portfolio, given the constraints on amounts available for investing and the skills for managing it. Instead, investing in a mutual fund which aggregates investable amounts from a large number of investors with similar needs from their investment or investment objective, will allow investors to participate in a well-diversified portfolio instead of building an inefficient one themselves.