Building Your Financial Pyramid- Series IV (Level 3 Growth & Diversification)

In the earlier articles, we saw how the initial base of protection and regular savings can save you against financial turmoils of life. A stronger base of your financial pyramid helps you to lead a more anxiety-free life. 

We have already taken two steps and now reached the Third level that is “Growth & Diversification”. 

Life is like a carousel, it never stops turning. You have to come out of your safe zone and accept volatility in order to grow your investments as well. We have to be honest about what we want and take risks rather than lie to ourselves and make excuses to stay in our comfort zone.

Diversification is about not relying completely on a single investment. In a diversified portfolio, the assets don’t correlate with each other. When one rises, the other falls. It lowers overall risk because, no matter what the economy does, some asset classes will benefit and that offsets losses of other assets. Risk is also lower because it’s rare that the entire portfolio would be wiped out by any single event. A diversified portfolio is your best defence against a financial crisis.

How much should you own of each asset class? There is no one-size-fits-all best-diversified investment. You need to use asset allocation to collect a mix of stocks, bonds, commodities and other classes. Your choice of asset classes has to purely depend on your comfort with different risk levels, your goals, and where you are in life. 

For example, stocks are riskier than bonds. If you need the money in the next few years, you should hold more bonds than someone who could wait 10 years. Therefore, the percentage of each type of asset class depends on your personal goals.

Bonds

Bonds are also called ‘fixed-income assets’ because they offer cash flow at a fixed rate. But if bonds have lower returns than stocks, why bother owning them? Because this investment can help you avoid sleepless nights that can be associated with owning stocks, which are perceived to be riskier. 

This investment helps to cater to the near term non-negotiable goals. Once you know created enough safe zone investment for your portfolio, then you can go to other asset classes.

                                                                             Stocks

With the soaring cost of living and decreasing bank interest rates, you need an investment class that enables you to beat inflation and increase your purchasing power. The base value of Sensex was taken as 100 in the year 1979, which indicates investment in that would have given an annual growth rate of more than 16%. Stocks have outperformed other asset classes.  Definitely, volatility is attached with equity investment and that helps generate wealth when money is invested in quality stocks with proper research.

 

Mutual Funds

When you invest in a mutual fund, your money is combined with the other investors, and that allows you to buy part of a pool of investments. You get professional quality management at a shared cost.  Directly investing in stocks is a good option but that requires diversifying into different sectors and sub-sectors plus constantly monitoring the market change. Which is not a very feasible option for everyone? But through Mutual fund with a small sum of money, you get the benefit of diversification and professional management. It offers a variety of categories based on your goals, risk-appetite and tenure of investment. 

ETF’s:

ETFs and mutual funds both involve pooling money that becomes part of a big fund invested in a mix of different assets.  It simply copies an index and endeavours to accurately reflect its performance. It allows you to avoid the risk of poor security selection by the fund manager while offering a diversified investment portfolio. The stocks in the indices are carefully selected by index providers and are rebalanced periodically. ETFs offer anytime liquidity through the exchanges.

With so many investments to choose from, it may seem like diversification would be easy to achieve, but that is only partially true. The basic objective of diversification is to reduce risk, which can be done by investing in fixed income or government-backed schemes but that will hamper your fight against maintaining your purchasing power and achieving your financial goals.

You still need to make wise choices or otherwise, there is a possibility of over-diversification in your portfolio, which will negatively impact your returns.  Having too many investments in your portfolio will defy the core purpose of growth from diversification. You need to strike a proper balance between growth and diversification with diversified asset allocation. Also, you need to rebalance your diversified portfolio with the changing phases of the market.

 

Have any further queries? Sound us off in the comment box below!