To build wealth, you need to make sure the value of your money grows over time. For this, you must invest in such a way that the return on investment can largely beat the rate of inflation without exposing the capital invested to much risk.

Diversification

To reduce the risk of losing all your capital, you should either diversify your investment or invest in an investment product with a diversified portfolio.

“Diversification is the key to a risk-mitigated wealth creation journey. Different asset classes are exposed to varying risks at different times. Without diversification, a portfolio is likely to experience extremely high volatility. In an extreme scenario, the portfolio could experience a complete decline, thereby eroding wealth within days, which has been accumulated after years and decades of hard work,” said Pawan Parakh, Director and Portfolio Manager, Renaissance Investment Managers.

Parakh lists the following benefits that diversification provides:

Reduces the impact of market volatility

The past 3 years have seen unprecedented volatility across most asset classes viz. equity, debt and commodities, among others. Even otherwise, a crisis typically hits the global economy every 3-5 years. In such a case, the concentrated stock portfolios would suffer a massive decline. Contrary to this, a diversified portfolio would be much more resilient as other asset classes like debt and gold would act as a hedge. This helps in making wise decisions which can further help maximize returns. During times of uncertainty, when equities experience a sharp correction and several high-quality stocks are available at attractive valuations. An investor with a diversified portfolio can capitalize on this situation by shifting part of the allocation from debt/gold to equities. The correct asset allocation can then be restored once the equity market normalizes.

Provides liquidity

The ease of liquidity is another benefit of diversified liquidity. Investors should be aware that the liquidity profile is different for different asset classes. For example, real estate is generally a very stable asset class, but it is not as liquid an asset as stocks, gold or debt. A large, concentrated real estate portfolio could provide regular returns but do very poorly in times of immediate cash need.

Generates superior risk-adjusted returns

A risk averse investor should also diversify their holdings within a particular asset class. For example, within the debt portfolio, exposure should not be limited to a few entities. Rather, it should be diversified across issuers and across maturities, if possible. The same goes for stocks and real estate. Putting all the eggs in one basket is never a prudent investment strategy from a risk perspective. Investors who take a systematic and disciplined approach to investing end up generating superior risk-adjusted returns, which is critical to building long-term wealth.