It is a fundamental principle that risk and returns are directly related. Being conservative lowers your returns. While being aggressive attracts more returns. But you will face the risk of losing your initial capital. The key to creating an ideal investment portfolio is to maintain a balance between the risk and returns.

And you can summarize it in a word: Diversification. Want to learn the art of diversification? Here you go.

Diversification: The Secret of Ideal Portfolio

Diversification is the art of allocating your investments in various asset classes. It works on the principle that ‘Don’t put all of your eggs in one basket.’ It ensures that you can earn adequate returns without facing significant risk.

Here's a fun fact: You can diversify time itself. Like a SIP, you can invest periodically. It helps in averaging the cost. And it also makes you disciplined about investing.

No doubt diversification is necessary. But remember that ‘Excess of everything causes more harm than good.’ Let’s understand why you should avoid over or under diversification.

Over Diversification

Diversification helps to reduce the overall risk and even set off losses. But excess diversification may do more harm than good. I.e., it may decrease your returns.

Suppose you invest Rs 5000 in 40 stocks. If one of your stock trebles itself, you will be on cloud nine as you found a multi-bagger. But the reality will hit you hard when you see that your portfolio increased by a meager 5%.

Under Diversification

You should have understood why you shouldn't diversify excessively. But under diversification is no good as well. By concentrating on your investments, you increase the overall risk.

Suppose you invest your entire capital in 3-4 stocks. How will you react if one of them turns out to be ITC ;) You will lose all hope of getting the desired returns. Also, the capital invested may diminish due to an inevitable evil called inflation.

The Ideal Investment Portfolio

Now you should know why it is crucial to diversify your portfolio appropriately. Don’t know how to do it? Well, here’s help:

Equity Portfolio

● Number of Stocks: Ideally, you should invest in 15-20 stocks. Investing in 4-5 stocks will lead to an over-concentration of the portfolio. On the other hand, investing in 40-50 stocks decreases the returns. After all, you aren't aiming to launch a mutual fund, are you?

● Allocation in stock: 5-8% is the ideal allocation in a stock. Don’t get attached so much to a company that you invest 20% of your capital in it.

● Allocation in a Sector: You can't call it diversification if you invest in 15 stocks of a specific sector. What if you invested in the hospitality sector? And there is another pandemic. You may not be able to recover the losses for a long time.

So, try to invest in 5-6 sectors. And don't invest more than 25% in one sector. If one industry falls apart, others can hold your portfolio, except when there is a nationwide recession. What's more, the sectors shouldn't be highly correlated.

Before moving forward, keep in mind that the diversification criteria consider investing through mutual funds. Also, you can invest in international stocks to diversify your portfolio to the next level!

Other Instruments

As mentioned above, diversification doesn't mean investing entirely in equity. Generally, equity is considered a risky investment. To balance the risk, the presence of other instruments is vital as well. Here are some of them:

● Gold: No doubt you may consider it an old-age investment. But trust me it is underrated! It is a safe haven asset. It is so because there is an inverse relation between gold and stock markets. If the entire stock market fall, it can mitigate the losses. So, you must include it in your portfolio.

Are you worried about the charges and the security? Not anymore. You can invest in sovereign gold bonds. It solves these problems and earns you interest as well.

● Bonds: They are like a mix of stock markets and bank deposits. They help you earn more returns than Fixed Deposits. And that too at lower risk than equity. If you are unable to invest in bonds, you can invest in debt mutual funds as well.

But remember to invest in safer bonds only, i.e., AA category or above. It is no use investing in risky bonds for higher returns. You may even lose your invested capital. Instead, it will be more beneficial to invest in equity.

● Real Estate: It is evident how the property prices are soaring high. Nowadays, you will realize how difficult it has become to own a property in established localities. The rent can become a significant source of passive income.

If you don't want the hassle of owning real estate, you can invest in a Real Estate Investment Trust (REIT). They are like mutual funds investing in properties. You can earn rent without investing lakhs of crores! Sounds exciting, right?

● Startup Funding: 2021 will be recognized as the year of startups. Seeing a startup becoming a unicorn has become daily news. Perhaps, there be a new title, considering that unicorns are not so rare nowadays.

Anyways, investing in startups has the potential to fetch you high returns. But don't forget that risk will be higher as well. So, it will be better to invest through venture capitalists, as they have the professional skills and capabilities to find the next unicorn.

Closing Words

If you have read till here, you would have realized how difficult it is to create an ideal investment portfolio. If it is that easy, everyone would be as successful as Warren Buffett or Rakesh Jhunjhunwala. But that isn't the case.

It doesn't mean that you shouldn't try to become successful. It is acceptable to make mistakes as long as you learn from them. As it is rightly said. 

The greatest mistake is to be afraid of making one.

In the end, remember to research properly before investing.