Every financial instrument has certain inherent risks. Some instruments like equities have higher risks while others such as fixed income securities face risks due to interest rate movements.
When you invest, you need to set and maintain the strategic allocation among different asset classes for building wealth over the long-term. Diversification is beneficial in managing the risks. This strategy provides the opportunity to deliver returns based on your financial objectives, investment horizon, and risk tolerance.
How diversification works
To ensure your investment portfolio is diversified, you must invest in various instruments such as equities, mutual funds (MFs), bonds, and others. This ensures that if one instrument does not perform well, the loss is mitigated by favorable movement of other financial products. You must also diversify within each investment instrument to further mitigate your risks. For example, if you invest in mutual funds, you must include different funds like thelarge, small, and mid-cap, various sectors, and more. Similarly, if you invest in bonds, consider including instruments with different maturities, duration, and credit ratings.
Diversification is not a one-time strategy
Just like investing is a continuous process, diversification is also not a one-time strategy. Here are three aspects of ensuring constant monitoring and rebalancing.
- Customized investment plan
Even before you invest in MFs, bonds, stocks, or other products, you must develop a customized investment plan. Additionally, you must determine your investment horizon and risk appetite to choose the most appropriate financial instruments.
- Risk tolerance investments
Based on your risk tolerance, you must choose the right combination of bonds, stocks, and other financial instruments. Historically, equities have delivered higher returns that beat the rate of inflation in the long-term. However, if you have financial goals in the short-term, stock investing may not be an appropriate strategy. Investing in short-term instruments or bonds may be more beneficial. Once you determine the right asset combination, it is recommended you research different investment options and make your decision.
- Regular monitoring
Periodically reviewing and monitoring your portfolio is crucial. Monitoring enables you to evaluate your holdings for any modifications in performance, strategy, or risk. If any rebalancing is required, you must make the necessary changes to ensure your ideal asset mix is maintained. Financial goals are dynamic and change based on the point in your life. Therefore, it is important to reconsider your financial plan and investment strategy with changes in your goals.
Stock, bonds, and mutual fund investments have certain tax implications. In addition to diversifying your portfolio to ensure your ideal asset allocation is retained, you need to determine the tax implications of such changes. It may be beneficial to take help from an experienced professional if you do not have the expertise.