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Tuesday, March 23, 2010

The Importance of Diversification

As the manager of your portfolio, you need to understand the importance of diversification. There will be periods when some of your holdings will lose money. When that occurs, you need other investments to offset the decline.

Diversification is important to all investors. It’s something that socially responsible investors in particular need to notice because their universe of investment options is smaller than that of traditional investors. When creating a portfolio, it’s important to be sure that the elements within it not only meet your social or environmental concerns, but that they don’t create unwanted risk to your capital by being slanted one way or another.

Asset Allocation

One form of diversification is asset allocation. By having elements of different investment classes in your portfolio - including stocks, bonds, cash, real estate, gold or other commodities - you can protect your portfolio from losing the value that it might if it only contained one failing asset category.

When stock prices fall, for example, bond prices often rise because investors move their money into what is considered a less risky investment. So a portfolio that included stocks and bonds would perform differently than one that included only stocks at the time of a stock market drop.

It’s also wise to diversify within asset classes. Investors who loaded up on tech stocks in 2000 lost their shirts when the dot.com bubble burst and technology shares rapidly fell out of favour. Similarly, financial stocks were hammered down in late 2007 and early 2008 due to the subprime mortgage crisis.

And if it seems risky to put all or most of your money into a single sector, it would be even more so to do the same on a single stock. Investors should not invest entire sum in a single stock (that’s what many investors did in past being an employee of the same company)
 
So the two steps to diversification are to spread your money among different asset categories, then further allocate those funds within each category. A smart approach for individual investors is to diversify using mutual funds. Because mutual funds are groups of stocks, you’ll be diversified to a certain degree by definition.

Getting Started

But you should go one step further by buying different types of funds. Many advisors recommend beginning with a broad-based index fund that merely tries to mirror the performance of Sensex or Nifty. Then you could complement that index fund with a fund that purchases shares in overseas companies; one that consists of shares of small growth companies; one that invests in bonds and another that buys shares in real estate investment trusts (REITs).

At web sites such as moneycontrol, ndtvprofit and valueresearchonline.com, you can find analysis and information about mutual funds to get you started. Remember to notice fees and expenses when comparing funds.

By diversifying your portfolio, you’ll give yourself an opportunity to grow your money despite the ups and downs that come with investing.

Calculated Risk

Once you find yourself ready to take a bit of risk with your investments, invest a small pie of your investments in small and mid cap stocks because investing directly in stocks give a chance to investors to get the maximum returns compared to investment in mutual funds. It will not include any fund manager fee, advertisement cost, entry & exit load and give a chance to investor to earn the maximum in terms of regular dividends, higher dividend yield and appreciation in stock price with scope of stock bonus & split.