Diversification means spreading your money over a number of investments. In other words, you don’t concentrate your money over just one or two, or only over a few investments. For instance, if you have an investible surplus of Rs 1 lakh, you can diversify into two ways. Firstly, don’t invest the entire Rs 1 lakh in just one asset class. Allocate the amount among 2-3 asset classes. For example, instead of investing the entire Rs 1 lakh in say, equity, invest a portion in equity, another portion in mutual funds and the balance in debt. Secondly, within each asset class you are investing in, don’t invest all the amount allocated to that asset class in only one or two investments. For instance, if out of Rs 1 lakh, you have decided to invest Rs 35,000 in equity, don’t invest the entire Rs 35,000 in shares of just one company. Allocate this amount between 2-3 companies at least.

Diversification - benefit and pitfall. Diversification is a well-established risk management investment strategy. It helps spread your risks over investment options offering different risk-return levels. Diversification especially helps when one invests in investment options with complementary risk-return profiles. For instance, it has been historically proven that when the equity markets are on a bull-run, the debt markets are usually sluggish. Now, if you invest in a combination of equity and debt, you are protecting your investments from a significant fall. In other words, if you had only invested in equity and the equity markets were in a bearish situation, you would have made significant losses on your investments. However, by investing in both, debt and equity, a portion of your portfolio, which is invested in debt, will offer profits during this time to reduce the losses on your equity investments, resulting in either an overall lower loss, or even a marginal gain depending on the level of investment in debt. The reverse will hold true if the equity markets are moving upwards and the debt markets are stagnant.

However, diversification also results in lower profits. For instance, if you had invested only a portion of your portfolio in equity, and the equity markets are in a bull-run phase, you would make profits on only the portion of your investments made in equity. The portion invested in debt would not offer the same level of profits, or may even result in losses. Having said this, diversification helps cap losses, which is important, especially for risk-averse investors.

Diversification methods. Diversification can be done across different asset classes (equity, debt, mutual funds, gold, property, etc.) as well as across different investment options (say, in case of equity – investment in companies with different market capitalisations, in different sectors, etc.). The amount of investment made in each asset class and investment option will depend on your investment risk profile and expected investment returns.