With risk comes reward. In everyday life, you can see this. A risk could be as simple as trying a new restaurant. While the downside of taking this risk is small – having an unsatisfactory meal – the reward could come in the form of that restaurant becoming your new favorite eatery. A larger risk could be quitting your job to start a new business. The upside could be a financial windfall but you are potentially risking a loss of a stable income.
The markets operate similarly: small risks generally have smaller rewards while riskier investments tend to have larger possible returns. To minimize downside risk, you can diversify your investments. Diversification is ‘spreading your eggs across multiple baskets’ so that if any particular investment has a loss in value, other investment gains could offset that loss.
Below is the Upstox Periodic Table of Returns for the last 15 years. There are several asset classes represented including: large cap stocks, small cap stocks, long term bonds, short term bonds, and gold. We have also included US stocks and an illustrative diversified portfolio. The key takeaway is that no asset class is consistently ranked as the best year-after-year. For example, in 2008 when the financial crisis occurred, short term bonds far outperform other asset classes with a return of 23.5%. In 2009 and 2010 when the global economy improved, short term bonds still provided a positive return but were the worst performing asset class in our list. Going forward, short term bonds were ‘middle of the road’ across asset classes in 2011.
While you can’t guarantee that an asset class will perform the best consistently, diversification can ensure that your investments won’t perform the worst. In our Periodic Table of Returns, the Diversified Portfolio (shown as a black square), is a weighted combination of large cap stocks, small cap stocks, long term bonds, and gold. Our illustrative Diversified Portfolio consistently performs in the middle because when one class does poorly, that loss is offset by another asset class that has a favorable return.
Overall, investment diversification has the following benefits:
- Smoothing Out Returns: Diversification can help smooth out your investment returns over time. This means that your portfolio may experience less volatility, which can help you avoid emotional reactions to market swings and stay invested for the long term.
- Improving Long-Term Results: Over the long term, diversification can help you achieve better investment results. By spreading your investments across multiple asset classes, you are more likely to capture the returns of the overall market, rather than relying on the performance of a few individual investments.
- Reducing Risk: By investing in a variety of assets, you can reduce the risk of losing money in any one particular investment. This is because different assets tend to perform differently in different market conditions.
While we have been discussing investing in multiple asset classes in order to diversify, the same concept applies to individual securities. For example, you can diversify your large cap holdings by owning a mutual fund or ETF indexed to the Sensex or Nifty50 instead of merely owning one or two stocks like Reliance or Infosys.