While doing Investment Diversification is important

We have heard many a times that one should have a Diversified investment. But “why” and “how” is the question we all have.

Also, the sentence “Covering a loss” is very common amongst us, but is it the same we do when we incur a loss in the stock market?

Most of the people who invest in the stock market are not very adaptive to the technical analysis. It is the call in the market or the people around them or the brokers asking them to take a buy or sell action. Some business man, on the basis of some heard facts invests and then incur a loss. Hardly few tries to analyse the reason behind the cause of the loss and small portion of those few try to find a way to cover up the losses.

Here, we are going to discuss to diversify the risk (i.e. investment).

Yes, it is a fact that people are moving towards mutual funds, portfolio managers because people have understood that diversifying the risk is very important.

To understand the diversification of risk, first of all, let us understand what is Mutual Fund?

A fund company which invests investor’s money in various shares of the companies. So taking an example if I have Rs. 5,00,000 then rather investing my whole amount in TCS, a mutual fund would diversify the same fund into TCS, Reliance Industries, Hindalco, etc.

WHAT IS DIVERSIFICATION OF RISK?

When we have a sum of money to invest, we have 2 options.
Either we invest it fully in one company or in one industry (e.g.: Pharma, Telecom, Chemicals, Cement, etc); or

We divide that fund and invest in different companies, i.e. the dissimilar companies(Dissimilar companies means companies of different sector. E.g.: TCS & SUN PHARMA).

The second point is known as diversification of investment/risk. When we do not rely on a single sector(industry) or a single company, and we invest in different sectors and companies, we are doing diversification.

WHY DIVERSIFYING RISK?

There are a lot of industries in the market. We can call it Pharma, Power, Chemicals, Textiles, Steel, Finance, IT based, Cement etc. Those all industries have some relation with the market. It can be direct or inverse. Those industries react with the market movements. Usually, companies in Pharma sector will react in the same way to the market but a company of Pharma and a company of IT sector would react differently.

They all have a relation with the market i.e. NIFTY & SENSEX (popular market indexes).

DIRECT RELATION: A share may increase with the increase in the market and may decrease with the decrease in the market index. That means if the SENSEX or the NIFTY falls by some points, the share will also fall by some points and if the SENSEX or NIFTY soars by some points, then share will also rise by some points.

INVERSE RELATION: When the share reacts exactly opposite to the market. That means when the NIFTY or SENSEX rises, the share shows a downward movement and when the NIFTY or SENSEX falls, the share shows an upward movement.

These relations play an important role in deciding an overall earning from a portfolio.

A portfolio is simply your finance bag which shows your investment into different shares and securities.

Suppose, an individual has a portfolio in such a manner that it contains only those share which has a direct relation with the market movement then he is at a big risk if the market moves down. But if the same individual possesses a ratio of shares, i.e. some shares of direct relation and some of the inverse relation then that individual would be able to protect himself from incurring huge losses.

Now, finding such a ratio which would be viable for an investor’s portfolio is the job of an analyst. On the basis of such analysis, the Mutual Fund companies invest into different shares and securities.

But is that it?

Just the ratio or also the intensity of the market movement hitting the movement of the share of the company?

We now understand that the relations are important but the intensity is equally important. What is such intensity?

There is intensity relation between a share and the market.

Such Mutual Fund companies and also the analysts find out such rate which shows how much (i.e. what %) a company’s share will increase/decrease if the market increases/decrease by certain points.

So, we must keep in mind that diversifying the risk will always tend to give a positive or no return rather than giving a negative return in recessionary times.

One cannot conclude that diversifying our investment would have no loss portfolio. A portfolio may incur loss if it’s not well prepared, but such loss would be always less than the loss which would have incurred if the investment was only into one sector.