A portfolio is a collection of investment assets owned by you, which includes securities such as equities, bonds, mutual funds, real estate, gold and any other financial instrument that you may have. Think of a portfolio&nbsp;as your wardrobe; you have clothes and accessories to suit different occasions or/and seasons, but it also includes clothes for daily use. Typically, a good investment portfolio contains a selection of investments that are tailored to suit your risk tolerance, which depends on your age, financial and life&rsquo;s circumstances besides the financial goal towards which you are investing.

 What is a portfolio?

An investment portfolio has far-reaching advantages. An obvious benefit is the convenience of accessing your investments. As portfolios are accessed digitally these days, a single window access to your investments allows you to know where you stand; something like looking at yourself in front of a mirror. Portfolio allows you to track the progress made by your investments as well as provide you with the option to modify it to suit your life and financial circumstances.

Remember; all investments have some form of risk and a portfolio provides you some control over how your investments fare in future. Your financial portfolio acts like a tool, helping you make important financial decisions in life. If you use a fitness tracker; the dashboard view provides you with where you stand on different parameters, something that a portfolio view indicates about your finances.

Importance of a portfolio 

Distribution of your investment portfolio into different asset classes such as equities, debt and cash equivalents etc is asset allocation. Think of asset allocation like a thali which has starters, main course and desserts, besides being wholesome with a little bit of all the vital nutrients &ndash; carbohydrates, proteins, vitamins, sugar and fat etc that are necessary for one.

Like a thali works for the choice and variety it offers to make for a wholesome meal; asset all allocation works because different asset classes perform differently to changing economic and financial market conditions. Moreover, with asset allocation you can maximise your portfolio returns and minimise investment risks. For instance, someone young at 25, with no immediate financial commitments can go with an asset allocation that has as high as 95% allocation to equities, with the remaining in debt and cash.

Asset allocation

Diversification is spreading out investments at two levels &ndash; across asset classes and within asset classes. So, diversification across asset classes is somewhat like asset allocation &ndash; equity, cash and debt. Whereas, diversification within asset class is like having allocation to sectors, companies across market capitalisation and type of stock when investing in equity as an asset class. In case of debt it could be short-, medium- or long-term debt or in government securities and bonds etc.

A primary motive for diversification is to ensure a mix of financial instruments and asset types in one&rsquo;s portfolio. An ideal diversification strategy involves creating a portfolio of various assets that earns the highest return for the least risk. When diversifying investments within an investment type you will have greater potential for growth because your portfolio is not dependent on anyone type equity investment. For instance, when investing in equities you can invest in different companies, industries, sector, countries, and business sizes providing you diversification within the equity asset class.

Diversification

Many a times the two terms are incorrectly used interchangeably. While asset allocation is the process of determining the right mix of investments you should own; diversification is the variety of investments within the same asset class in your portfolio. For instance, asset allocation is like spreading your food intake to breakfast, lunch, dinner, laced with snacks and beverages. However, diversification would amount to what you specifically consume during each meal. For instance, your breakfast may include eggs, toast, juice, coffee and flakes, whereas a pre-lunch snack could be a juice or a fruit etc.

For optimum portfolio outcomes; a diversification strategy needs to be implemented hand-in-hand with the asset allocation strategy. Think the mix of the two as a well-balanced healthy diet. Together, the two offer exposure to risk that fits an investor&rsquo;s risk tolerance while minimizing downside potential due to the wavering of one or more individual holdings.

Asset allocation vs Diversification

Asset allocation can help you preserve capital by protecting your investments. Asset allocation is based on the investment risk that you can take, which can help you minimise loss by reducing the potential loss by spreading your investments across different asset classes. More importantly, with asset allocation, you will be able to generate portfolio returns because different classes are differently correlated to each other &ndash; so when one fares well, it offsets the performance of the ones that haven&rsquo;t performed as well.

Importance of asset allocation

Diversifying your portfolio can help you smooth out market ups and downs. Markets tend to move in different cycles reflecting the underlying strength of the economy, industry trends and investor sentiment. It is for this reason that individual assets move differently according to external factors.

For instance, during hard economic times the luxury and entertainment sector may take a hit, but essential items such as FMCG tend to and sometimes even improve their performance. By diversifying, you have the option to maintain&nbsp;the return from performing assets compared to those that are not performing well.

 Why you need to diversify?

Value of investments in a portfolio changes with time owing to variations in the markets; this could change the portfolio&rsquo;s risk level. It is important that you keep an eye on how your investments are doing and periodically adjust your asset allocation and diversification.

Rebalancing is bringing your portfolio back to your original asset allocation mix.

For simplicity, assume your portfolio has Rs 70 in equities and Rs 30 in debt. Now, after a year the equity component has gone up in value to Rs 95 and the debt to Rs 35, making your portfolio&rsquo;s worth to Rs 130. However, the allocation now has changed &ndash; 73% in equities and 27% to debt. To rebalance them to the original 70% in equities and 30% in debt level, you need to reduce the equity allocation by selling some of it Rs 91 and switch the balance Rs 4 to debt, taking it to 39 to rebalance the portfolio.

By rebalancing, you will ensure that your portfolio does not overemphasize one or more asset categories, and you will return your portfolio to a comfortable level of risk. In the long run, periodic rebalancing reduces investment risk and helps you cope with volatility.

What is Rebalancing?

Performance of different asset classes changes over time. The effect of such movements impacts the asset allocation ratio between asset classes that you started with when building the portfolio. A portfolio rebalance is simply the act of returning to your pre-determined asset allocation that is based on your risk profile. 
You could rebalance your portfolio depending on circumstance or triggers set by you to rebalance. If the asset allocation variation between two asset classes skews by over 10%; you may wish to rebalance the portfolio. Alternatively, you may wish to use an annual rebalancing exercise to bring your portfolio asset allocation to the same level with which you started the year. A good habit is to review your portfolio annually to know what has changed in it and take necessary steps to rebalance.

 When you need to rebalance? 

The art of portfolio is simple &ndash; you reduce the holdings of the asset class which has shot up and use the proceeds from this exercise into the asset classes which will rebalance the portfolio to the original levels.

Rebalancing can be achieved by exiting by way of selling some part of the gain in an asset class and using the proceeds to the asset class that needs this proceed to attain the original balance. Rebalancing can also be achieved by increasing your investments to an asset class in a way to balance the portfolio to the original allocation instead of reducing your holdings in an asset class that has gained significantly to offset the gains to the asset class that needs addition to reach the level you started with.

Although this process sounds simple; investors need to be disciplined to rebalance to reap the benefits of portfolio rebalancing.

Portfolio Diversification

What is a portfolio?