Diversifying portfolios with strong stocks can mitigate risks and enhance returns

Shahid was a 21-year-old college student who had saved ₹60,000 from his weekend job at a computer repair shop. Every month, he carefully put aside ₹5,000 from his earnings. After two years of saving, he looked at his bank balance and realised his money was not growing much due to low interest rates. 

His friend Rohan, who studied finance, noticed Shahid's frustration and said, "Your money should work for you too!" 

Curious, Shahid asked how ordinary people could grow their savings safely. Rohan explained basic investment principles using simple examples from everyday life. Intrigued, Shahid decided to learn more about making his money grow while protecting it from big risks. 

How did Shahid turn his ₹60,000 into ₹68,400 in just 12 months without taking dangerous chances? In this blog, we will discover his smart strategy.

1. Risk Mitigation Through Diversification

Diversifying a portfolio means investing in different types of assets to reduce risk. If one investment performs poorly, others may perform better, balancing the overall outcome. This strategy helps protect against significant losses and can lead to more stable returns over time.

Let's consider an example of a boy named Shubham who has ₹1,00,000 to invest.

In this diversified portfolio, if the stock market underperforms, the bonds and real estate investments can help mitigate losses, providing Shubham with a more balanced and secure investment strategy.

2. Enhanced Return Potential

Diversifying a portfolio with strong stocks can increase the chances of earning better returns. This is because different stocks perform differently over time. When some stocks go down, others may rise, helping balance the overall performance.

Let’s look at an example of a boy named Umesh. He had ₹1,00,000 to invest. Instead of putting all his money into one stock, he invested in 3 different companies. This way, he reduced the risk of losing money and increased his chances of gaining more.

Here is a simple table showing how Umesh diversified his investments:

By spreading his investments, Umesh earned ₹4,900 in one year. This example shows how diversification with strong stocks can help in achieving better returns while managing risks.

3. Capital Preservation

Capital preservation means keeping your money safe and avoiding losses. It is important for people who want to protect their savings, especially when markets are uncertain.

Example: Payal invested ₹10,000 in a low-risk fund. After one year, her investment grew to ₹10,500. This shows that even small, steady growth can help preserve and slightly increase her money over time.

Payal's Investment Summary:

This example shows how choosing safe investments can help maintain and grow your money gradually.

4. Exposure to Growth Opportunities

Investing in different areas can help you grow your money. When one area is not doing well, another might be doing better. This is why it is important to invest in various sectors and markets.

Example: Ragni's Investment Portfolio

Let's look at Ragni, a young investor, and how she invests her money:

In this example, Ragni invests in different areas:

• Technology Stocks: These are expected to grow faster, so Ragni hopes to earn ₹6,000.
• Real Estate Fund: This is a safer investment, with an expected return of ₹2,400.
• Government Bonds: These are very safe but offer lower returns, about ₹1,000.

By investing in different areas, Ragni can earn a total of ₹9,400. This strategy helps her take advantage of growth opportunities while managing risks.

5. Improved Risk-Adjusted Returns

Investing wisely means earning good returns while taking on manageable risk. Risk-adjusted returns help us understand how much return we get for the risk we take. A higher risk-adjusted return is better because it means more profit for less risk.

Example: Let's look at Jay's investments to see how risk-adjusted returns work:

In this example, Jay has three investments:

• Stock A: Offers a 15% return but comes with a higher risk (10%).
• Stock B: Provides a 12% return with lower risk (5%)
• Bond C: Gives a 6% return with the lowest risk (2%).

To calculate the Sharpe Ratio, we subtract the risk-free rate (assumed to be 5%) from the return and divide by the risk:

• Stock A: (15% - 5%) / 10% = 1.0
• Stock B: (12% - 5%) / 5% = 1.4
• Bond C: (6% - 5%) / 2% = 0.5

From this, we see that Stock B offers the best return for its level of risk. Even though Stock A has a higher return, it also has more risk, making its risk-adjusted return lower. Bond C has the lowest risk but also the lowest return.

Conclusion

Diversifying your investments helps reduce risk and can increase returns. By spreading money across different assets like stocks, bonds, and real estate, you protect against losses and grow your wealth safely. Smart, balanced investing keeps your money secure while giving it the best chance to grow over time.

FAQs

1. Why is diversification important in investing?

It spreads risk, so one bad investment does not cost you all your money.

2. How does diversification improve returns?

Different investments grow at different times, balancing losses and gains.

3. What are some ways to diversify a portfolio?

Invest in stocks, bonds, real estate, and different industries.

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LoansJagat Team

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