by Dheer Kothari

Created on: January 20, 2012

Creating a well-diversified portfolio

The reason why you should have a well-diversified portfolio is that it gives you a protective cushion in prolonged bear phases and provides the trigger for above-average returns in a favourable market scenario. In addition, it is tax-efficient and hence generates better post-tax returns.

The process of creating a well-diversified portfolio is a bit arduous as it is built over a period of time and requires patience and elimination of under-performing assets by trial and error. Ideally, an investor should seek the help of a financial planner to take care of future financial needs by matching cash flows with requirement of funds not only during one’s working life but also post-retirement.

The first step to creating a well-diversified portfolio is to get a fix on the right mix of assets for your portfolio. This means having the right amount of debt, equity, commodities, gilt-edged securities, immovable properties and liquid assets like cash in hand. The right mix of assets for your portfolio would again depend on your tolerance.

Equity Shares- It is difficult to visualise a portfolio without shares. This is because no matter what your risk profile is, equity is a must for your portfolio because over a period of 10 years and above, equity does give you exciting returns and a ‘kicker’ effect to your portfolio. The equity component could be as low as 10 per cent or as high as 90 per cent depending on your risk-taking capacity.

Debt- Debt is equally important as it lends stability to your portfolio by providing steady returns. Its major disadvantage is that its value depreciates in a rising interest regime. The return on debt is inversely proportional to the ruling rate of interest. Debt is again classified into short and long term debt. Smart investors move in and out of short and long term debt based on their perception of to maturity.

Liquid instruments- These liquid assets are good for parking surplus funds and suitable for companies and individuals who seek returns on idle cash for very short periods ranging from a few weeks to a couple of months.

Commodities- Commodities like gold and silver, metals, grains and the like are meant for those who understand their market dynamics and demand-supply equation. Gold, in particular, is an excellent hedge against inflation and a preferred haven in uncertain times. Investing in exchange-traded funds (ETFs) can be considered by those who cannot afford to buy gold directly or are more comfortable leaving this job to professional managers.

You have to literally build your portfolio brick by brick. There are no short cuts. A vital component of any portfolio is the cash holdings which can be in the form of cash or cash-equivalents (for example liquid mutual funds). You can tweak your cash holdings according to the demands of a growing or stagnant/falling market. You cannot possible have a risk-free portfolio no matter how well diversified it is. There are some market risks which affect all stocks and cannot be avoided. This is why it is important to keep a hawk eye on your portfolio so that you can weed out non-performing assets to protect your capital.

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