Investment in share market comes along with a no. of risk associated. There are various ways to reduce that risk and multiplicity is the most practiced one out of those various ways of risk reduction.
Risk in Share Market is basically divided into two types, Diversifiable or Market risk and Un-diversifiable or systematic risk. And Investor has got to make peace with the systematic risk. But Market risk could be dealt with diversification.
Heterogeneity can save an Investor from losing all his money at once. There are various reasons for the stocks of a company or sector to perform good, excellent, bad or worst. It could be economical factors, political factors, environmental factors, war situation, evolution of technology, changing trends, demand and supply etc. Whenever any danger hits the Capital Market, it won’t affect all the sectors by same extent. The damage would vary from sector to sector depending upon the nature of the fluctuation which has occurred. And not only that, even the sector which is affected the most will be having companies with various degrees of damage caused to them.
No matter however long duration one spends on technical analysis of stock market, there will always be some risks that even the experts would be unable to smell beforehand. This is when DIVERSIFICATION helps.
Suppose a situation of flood occurs in most of the parts of country during Monsoon. Then the stocks of FMCG Sector will miserably fall down. But there would be some companies in the same sector that will be a little less affected because the regional boundaries that produce the raw material for that particular type of production was untouched by the flood. And then there is a rising trend in the transportation sector because suddenly exchange of goods has increased throughout the country.
But diversification again has to be well designed. There are various points to think upon. For example in how many stocks to diversify the money. How much money to be laid on bonds and how much of that to be put in equity market? Etc.
Bonds and Equity Market travel in opposite direction so loss in one is likely to be cancelled by gain in the other. People with smaller investments can opt this method of diversification because hedging and moving average techniques demand more money.
Another aspect that controls gain and loss is over diversification. There are studies that claim, diversification brigs good results if done among 20 verities of stocks in terms of sector, industry, company size, country etc. but over and mindless diversification has also led to historic failures in Indian Share Market and beyond.
Evidently the technique of diversification has proved to be useful in maintaining good returns at low risk but there have been events of failure also. Therefore there is no foolproof design of the same.