Risks and returns: Ideal portfolio diversification

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A well – allocated portfolio of about 10 to 20 quality market leader stocks from unrelated sectors neutralizes risks and returns ideally. Looking for better returns, equity-based assets such as direct stocks, mutual funds, and Portfolio Management Services (PMS) have massively gained the attention of retail investors over the past few years. One should also keep in mind that, trying to achieve life’s important financial goals through this risky asset section is not at all a simple task. 

Unpredicted experience of a financial market crisis and large financial losses have urged many of the mature investors towards a special preference for fixed income assets like bonds, fixed deposits, gold, etc. It becomes imperative for investors to understand the exact impact of psychological states on their investment decision making. This forces the investors to make ridiculous choices which would have a damaging impact on their investment value over the long term due to low returns and high inflation. 

 It is crystal clear that we need to invest a large share of our funds in equity-based asset classes to defeat inflation and gain higher returns than fixed-income assets. Yet, the inherent volatility in equity investments and the fear of losing capital frightens the investors because it’s their own hard-earned money, so one can’t complain about them.  

A common characteristic found in most people is that investor’s risk and return preferences are asymmetrical. They care more about staying away from the loss margin and achieve relatively good returns. Immature investors may think that investment through multiple funds or stocks would automatically reduce the risk of loss.  For that, they choose several investment alternatives based on past performance without thinking about the possible risk of capital loss. So, you need to understand that a simple addition of multiple stocks or funds would not necessarily reduce the future risk. Another way could be to magnify the risk of investors’ choice of stocks and funds are directly or indirectly linked with each other. For proper diversification, it is not that having more is always better as it could lead to over-diversification that can be a barrier for investment. It is a fact that on average, a concentrated portfolio with fewer holdings is less volatile than more diversified funds and also earns relatively higher returns. An over diversifies fund or a portfolio rarely beats the benchmark. 

Investors should have sufficient knowledge about the stocks they are holding to calculate the possible risks. This could be feasible only when the number of stocks is limited. Investment should also be well-distributed across all the sectors to avoid the risk of covariance among stocks itself.  

To finalize, diversification is desirable to reduce the risk but it could lower the returns. Therefore, it depends on individual choice. A well-distributed portfolio of 10-20 quality market leader stocks from unrelated sectors could be optimum for investment. 

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