Three tricks you can use to diversify your portfolio

The dictionary defines "Diversification" as an act of introducing variety. When it comes to investments, diversification is the rule of the game. It simply means having different types of instruments in your portfolio. For instance, if your investment portfolio has only asavings account, it's a concentrated portfolio; if it has a mix of fixed deposits, equities and some bonds, it is a diversified portfolio.

Diversification helps in managing the risk, since the value of your assets can change every now and then. In fact, since prices of different assets often move in opposite directions, having more than one asset in your portfolio helps limit the risk or impact of sharp price changes in one asset class.

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Here are three ways you can diversify your portfolio.

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Geographical: You could invest all your funds in India or you could choose to invest part of your portfolio in other countries. Such a diversification is called geographical diversification. The logic used is that different financial markets of the world are not necessarily too correlated to one another or prices don't always move in the same direction. In fact, when the rupee depreciated to as 68.80 against the dollar, and when international markets were doing well compared with the Indian markets, many chose to diversify across geographies. Remember, only a small portion of your portfolio should be committed to geographic diversification, if you are a lay investor.

Vertical:When you chose to invest across asset classes, it's called vertical diversification. Logic behind such a strategy is that even if one type of asset performs poorly, there is a good possibility that other assets in the portfolio will absorb the loss. For example, if you invest Rs 10 lakh in the equity market and the market falls, there is a good possibility that you will make a severe loss. But let's say if you would have invested that Rs 10 lakh in a mix of stocks, bonds and fixed deposits, the overall loss incurred could be limited. In fact, many planners believe that vertical diversification is the fundamental step when it comes to creating a healthy investment portfolio.

Horizontal:Unlike vertical diversification, which has various types of financial instruments, a horizontal diversification is more within a single asset class. Once the first step of vertical diversification is in place, you should look into horizontal diversification, So, within each asset class like equity or fixed income, you should ideally have more than one type of security. For example, in equity funds, you could invest in a healthy mix of large as well as mid-cap funds. Spreading your money across a single asset class is a form of horizontal diversification.

Likewise, when it comes to debt instruments, invest in more than one type of debt-oriented mutual funds with varying duration (the risk level in a debt mutual fund), you are spreading the risk across the same asset class or diversifying horizontally.

Important thing to keep in mind: Anything of excess is harmful, so is over diversification. So, you don't need to invest in 60 different mutual fund schemes, 6-10 MF schemes, keeping in mind the vertical, horizontal and geographic diversification should work well.