5 Ways to Diversify Your Investment Portfolio

Summary

• Investors choose to diversify their respective investment portfolios primarily to mitigate the risk associated with some class of assets.
• It is very important to hedge investment to decrease the exposure to uncertainties and market volatility.
• Common aspects like margin, ROE, ROIC, dividends and growth associated with an investment alternative can prove to be highly significant, while framing a diversification strategy.

You must have heard about several mantras to build a robust portfolio, one of them being diversification. In this article, we would discuss five ways that can help you diversify your investment portfolio.

Since risk is an integral part of the investment, diversification is said to be one of the strategies that can help mitigating the risk associated with a certain type of investment and reduce the volatility of an asset's price movements.

Notably, the recent scenario led by COVID-19 fuelled the uncertainty and volatility in the markets across the globe. Even today, investors’ confidence appears to be a little shaky, as the markets are not completely out of the shock.

Gold is considered as a haven for investors, and prices for gold were off on another tier, recently, where they reached an 8-year high. This shows how important it is to hedge your investment to minimise the exposure to the uncertainties and volatility in the market.

One important element of diversification is to diversify among different asset classes to mitigate general market risks that can affect almost every stock.

Let us look at some of the ways that can help to diversify your investment portfolio.

Margin

The amount that a brokerage firm lends to an investor to purchase an investment is known as the margin and is calculated when the total value of securities held in an investor's account is subtracted from the loan amount from the broker.

Often investors buy securities on the margin where the investor pays a certain part of his/her purchase, and the rest is funded by the bank or the broker.

An investor can choose to purchase securities using margin, but this comes with a recurring interest rate that must be paid. Investing through margin can prove beneficial for the investor, when there are chances that the rate of return on the investment is higher as compared to interest to be paid on loan.

A lot of investors fail to understand the role of margins, while making investment and end up making lesser income or even losses from their investment. On the other hand, if you understand the fundamentals of margins, you can make significant earnings through diversifying and buying on margin.

Return on equity (ROE)

ROE is a measure of financial performance that is calculated by dividing net income by stakeholders’ equity and indicates the effective utilisation of business assets to create profits by the management.

An average or slightly above-average ROE is considered good as compared to a very high ROE that is double or more than their peer group. You must be wondering why would stocks with a very high ROE not be a better indicator?

The catch is that, at times, ROE is higher due to the very large net income of the business, which is a good indicator of the robust performance of a business. On the other hand, ROE is higher when a business has very small equity account as compared to the net income.

Importantly, higher ROE in the latter case indicates higher risk for the business, as well as the investment in its stock as the business indicates several aspects like inconsistent profits, excess debt, negative net income, etc.

Return on Invested Capital (ROIC)

The return on invested capital takes the calculation of ROE (business’ ability to generate profits as compared to shareholders’ equity), a bit further and chalks out the amount that a business makes after dividends on the basis of its capital sources, including debt and equity of shareholders.

ROIC calculates how efficient the business is in distributing the capital under its control to profitable ventures and offers a sense of how much return business is generating by effectively using its money.

More significantly, the ROIC can be used as a yardstick to assess the value of other businesses. If a business has higher ROIC as compared to its cost of capital, it means that the business is growing and strong. However, if the ROIC is lower than the cost of capital, it suggests a shaky business model.

Naturally, as an investor, you would want to invest in a business that is stable and shows growth over a period.

A thin line separating ROE and ROIC is that ROE is indicative of the effective usage of shareholders’ equity; however, ROIC determines the efficient utilisation of all available capital to generate more money.

Dividends

Dividend is an amount distributed by listed entities to its stakeholders, which almost every investor is aware of. Moreover, it is one of the attracting forces that lure investors to invest in a certain stock. Generally, investors choose to invest in dividend-paying stocks to generate regular streams of income while diversifying income streams.

More importantly, dividends also indicate the health of a business as dividends are a part of businesses’ profit. Therefore, higher dividend generally represents higher profits of a business. On the other hand, if a company decides to cut dividends, it may indicate that the business is undergoing troublesome times.

Dividends can be tricky to understand at times. The decrease in dividends by a company may mean that a business is planning to invest in growth plans and thus is allocating more funds towards it.

Investors tend to invest in stocks that pay higher dividends; however, dividends may not be the sole indicator of a business’ health. Moreover, correct assessment of other aspects of the financial health of the business, and the risk associated with the dividend stocks is necessary to make a diversification decision.

Growth

A business that witnesses expansion and has room for further expansion to remain profitable is said to be a growing business. Moreover, stocks that are expected to grow at a substantial rate that is above the average growth for the market are known as growth stocks.

One common characteristic of growth stocks is that they do not pay dividends as they require more funds towards execution and acceleration of the growth strategy.

You must be wondering why do investors invest in growth stocks if there are no dividends?

It is because investors expect growth stocks to generate greater returns in the form of capital gains when they sell their shareholding.

As an investor looking to create diversification in his/her portfolio, growth stocks might look like offering great potential for substantial income in a short period. However, if a business runs out of operations, this can prove to be fatal for the investor.

On the other hand, investment in growth stocks that have strong fundamentals can be a good choice to diversify the portfolio.