InvestorQ : But, how do I actually go about diversifying my risk?
Anjana Aiyar made post

But, how do I actually go about diversifying my risk?

Deepa Salunkhe answered.
3 years ago

More than the actual diversification, it is the methodology of diversification that really matters. When you diversify, don’t go about blindly adding assets. Focus on internal correlations. A correlation of 1 means that the assets are perfectly correlated! Such assets do not give any diversification to your portfolio. The assets need to be actually different. But how do we decide that they are different? There are different ways to diversify. You can combine asset classes like gold or debt with equity; this is called asset class diversification. You can also spread across high rated bonds and lower rated bonds; this is called quality diversification. Spread your money across mid caps, large caps and small caps; this called size diversification. Also ensure that your money is spread across sectors to reduce your sector dependence; this is called thematic diversification. The key in all these cases is to ensure that the correlation is as low as possible. Even negative correlation can be useful but that is practically not possible to find too many such assets that are negatively correlated.

As much diversification is important, it can also be very challenging. Why is that? It can be challenging because diversification requires investors to make an informed investment decision on a number of investments. You may complain that you don’t have the time and resources to do all this analysis. Then a mutual fund does the job for you perfectly. Those who do not have the time, knowledge or desire to do the research required for diversification can diversify using a mutual fund or an ETF. These are more passive ways of managing your money. Through these vehicles, investors can delegate the research and selection process to the fund manager who pools funds and has more resources. Today, for most retail investors, the mutual fund route is the best one to diversify risk without taking on too much burden yourself.