As you spread your money across more asset classes, your overall risk is reduced. This is what we understand by diversification of risk. Your long-term risk will be dramatically reduced if you have assets that benefit from interest rate increases as well as assets that benefit from interest rate decreases when you have some assets that benefit from interest rate increases and some assets that benefit from interest rate declines. Instead of putting all your eggs in one basket, it is always better to spread your risk.

We must understand that diversification is more than just randomly spreading our portfolio across asset classes. It involves strategically allocating assets to reduce risk. Warren Buffett has always warned against over-diversifying, as the line between appropriate diversification and too much can be quite blurred, leading to Diworseification. To ensure effective diversification that lowers portfolio risk, we should approach it thoughtfully and carefully.

An 8-step checklist for ensuring meaningful risk diversification.

There is a general consensus that having a portfolio of around 15-16 stocks works best when it comes to diversifying. Adding more might reduce the risk, however, the marginal benefit diminishes quickly and beyond a certain point, each new stock just substitutes risk. Therefore, it’s essential to make sure your asset selection doesn’t exceed this limit to ensure that diversification is effectively reducing the risk associated with your portfolio.

There is no way to diversify if you are holding on to a stock and adding another that has a correlation of 1 with the previous stock. In order to reduce the risk of the portfolio, each additional stock should have a correlation less than 1 with the existing portfolio. In fact, the lower the correlation with the existing portfolio, the better the asset.

Unlike sectoral funds, equity diversified funds will spread their risk over a wide variety of sectors. So when a few sectors are outperforming, there are a few sectors that are stagnating and a few sectors that are underperforming. In general, the portfolio performs better than the market index. Although specific sectors in your portfolio may go through downturns, your portfolio remains protected as a whole.

It is also important to spread your assets across themes, so you may think that you have diversified your portfolio across banks, NBFCs, autos and reality. However, even though these are distinct sectors, they are all vulnerable to interest rate increases. In the event that rates go up, as is likely at this point, all of these sectors will perform badly, leading to underperformance of your portfolio. Therefore, diversification should be evaluated across themes, not just sectors.

When diversifying, be cautious of decreasing your returns. Gold is a good hedge in turbulent times, yet it often has been a gross underachiever. A 7-8% exposure to gold can be justified but if you go above 25-30%, then there isn’t much benefit, and your returns may suffer as a result. Keep this in mind when making decisions about diversification.

It is important to diversify within the framework of your long-term financial plan. When you diversify, you will change your asset mix, but you must not depart too far from your long-term financial plan’s original mix. After financial planning is all about discipline and it is likely to be successful only as long as that underlying discipline is maintained. You cannot disregard that discipline even for the sake of diversification.