Why you need to diversify your portfolio

Yesterday we saw the various options where you can invest your money (and also save tax). But you should make sure you shouldn’t put all your money in a single place. The risks are either you wouldn’t earn enough returns on it or you may lose all your money. That is the relationship between risk and reward.

More risk = More reward.
Low risk = Low reward.

The best solution to this, is to split your investment into various asset classes, so that you minimize risk and also get better reward.

Let me show you some examples of why putting all your money in one asset class is bad.

Investment Cycle

For quite a few years, everyone were investing in Gold, thinking it would always increase in value. But this year, after reaching new highs it began to drop quickly. Everyone who invested when the value of gold was reaching new highs, are now at a loss. And it would take many years for them to get profits.

This doesn’t apply just to Gold. There were many who invested in the equity market because the market was reaching new highs in 2008. But those put in all their money then, still are yet to recover and would take a few more years to become profitable.

So did people who had all their money in fixed deposit in 2003-2004, they didn’t participate in the bull run of the equity market. Their returns would have been very low than those who invested in shares.

What does this teach us? Every asset class follows a cycle. When one particular asset class is bullish, others wouldn’t be giving you any returns and sometimes would even be negative.

The best way to protect against this is to invest in all types of asset classes. But now is the question of how much to put in each class.

What percentage, in what?

It isn’t easy to say how much one should put in equity vs debt vs gold vs real estate without understanding your financial profile and risk appetite. But there is a simple rule of thumb that should work out, especially to find out how much one can invest in equity.

Take your age and subtract it from 100. That is the percentage of your investment that can be in equity. So if you are 25 years old, you can have 75% of your investment in equity market. “But, but, you said Equity was risky. I don’t want risk”. Yes. equity is risky, but if you keep invested in the long term, you minimize all risks.

Since you are just 25, you still have a long way to go and can thus put in more money a risky investment. The remaining 25% can be split into fixed deposits, gold, etc. By investing a majority in shares you would get a better return than just fixed deposits. When you grow older, you should slowly shift your investments from equity to debt which is more safer (but also rewards less).

TL;DR: Don’t put all your eggs in one basket. Split your money into different asset classes. Younger you are, the more risk you can take.

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