How to Build a Diversified Stock Portfolio

For many retail participants in the stock market, investing in shares is rarely an organised process. Most investors simply look for the hottest buzzing stock tips and add recommended shares to their stock portfolio without any analysis or research. The problem with building an investment portfolio in this way is that it overlooks the importance of portfolio diversification. 

If you too have been guilty of building a stock portfolio based solely on the trending tips, it may be time to revisit your strategy and prioritise creating a diversified stock portfolio.

In this article, we explain what diversification is, why it matters and how to build an adequately diversified stock portfolio.

What is Stock Portfolio Diversification?

Diversifying a stock portfolio involves spreading your capital across different companies based on specific criteria like size, geography, sector, industry and the like. It is an essential and recommended financial strategy for anybody who is investing in financial or non-financial assets. 

That said, diversification is particularly important for market-linked assets like stocks because of the risk involved. The stock market does not offer guaranteed returns, so concentrating all of your capital on a few limited and similar stocks can be a recipe for disaster. 

If the company, sector, or region you choose performs poorly, you face the risk of losing most or all of your capital.

Why You Should Diversify Your Stock Portfolio 

Before we get to how to build a stock portfolio, let us understand why it is important. Diversifying your shareholdings is essential because of the following reasons:

• Minimised Risk

Diversifying your portfolio helps reduce the overall risk. This is because the high risks in one category of shares may be offset by the lower risks in another.

• Optimised Returns 

Diversification may also optimise portfolio returns. This is because underperforming stocks may be offset by outperformers, so your overall returns may be stabler and more consistent.

• Leveraging Opportunities in the Market 

A diversified stock portfolio also makes it easier for you to tap into opportunities in different companies, sectors and geographies. This benefit is not available in a concentrated portfolio of investments.

• Peace of Mind 

Above all, by diversifying your portfolio, you can rest assured that your risks are not amplified due to over-concentration of your capital in one or few stocks. 

How to Build a Diversified Stock Portfolio?

Most investors may know that it is important to diversify their investment portfolio, however not many are aware of how to do so practically. If you too belong to this category of investors, check out the pointers below to understand how to build a stock portfolio that has low concentration risk.

1. Look into Different Sectors and Industries 

One of the most effective ways to diversify your stock portfolio is to include companies belonging to different industries and sectors. Stock portfolio diversification across sectors is important because not all sectors perform in the same manner.  Different sectors react differently to changes in market phases and economic cycles. Concentrating your shareholdings in one sector increases the risk of losses if that sector performs poorly.

To find stocks from economic segments that align with your investment goals, you need to perform a comprehensive sector analysis. This involves analysing key metrics about different sectors and interpreting them accurately. 

2. Invest in Companies of Different Sizes 

Another way to create a diversified stock portfolio is to include companies of different sizes in your asset basket. Market capitalisation can help you with this. It is the product of the total number of outstanding shares in a company and its current market price. Based on their market cap, companies can be classified as small-cap, mid-cap or large-cap entities. Each type of capitalisation offers distinct benefits.

Small-cap stocks may have more growth potential, large-cap stocks may be stabler and mid-cap stocks may offer a balanced mix of growth and stability. You can diversify your portfolio across different market capitalisations to leverage each of these benefits. 

3. Include Both Value Stocks and Growth Stocks

If you want to know how to build a stock portfolio that is diversified in terms of its goals, you need to look into value stocks and growth stocks. Value stocks essentially belong to companies that are currently undervalued. The rationale behind choosing such stocks is that with time, as the market realises the true worth of such shares and corrects itself, the value will rise — leading to capital appreciation.

Growth stocks, on the other hand, belong to companies that show a high potential for steep growth in the coming years. By including a mix of both growth stocks and value stocks in your stock portfolio, you can avoid the risk of concentrating your holdings on only one type of shares. 

4. Balance the Portfolio Risk with Defensive Stocks 

The equity market is inherently risky. One of the most common ways to mitigate the market risk in an equity-heavy portfolio is to include debt in your asset mix. However, if you do not want to reduce the proportion of your market-linked investments, you can consider portfolio diversification using defensive stocks. These stocks belong to companies in defensive sectors, which are not substantially affected by extreme economic cycles like recessions. 

This is because such sectors offer products or services that are considered essential irrespective of the economic cycle. Some examples of such sectors include healthcare, pharmaceuticals, FMCG, utilities, consumer staples and the like. 

5. Consider International Stocks

Your stock portfolio need not be restricted to domestic companies alone. Geographical portfolio diversification is also an effective way to reduce risks in an equity-heavy portfolio. Fortunately, with borders in the financial markets blurring, it is now easier than ever before to invest in international stocks. You can invest in the top stocks in global markets like Meta, Apple, Amazon, Microsoft, Alphabet, Netflix and more. Many international mutual funds are dedicated to investing in such global top-performing stocks, so you could consider them as worthy additions to your stock portfolio.

By diversifying into a different geographical region, you can minimise the risks associated with domestic or region-specific geopolitical risks. This adds an extra layer of stability to a heavily market-linked portfolio. 

6. Review and Adjust Your Portfolio Periodically 

Diversifying a portfolio is not a one-time endeavour. All the strategies to achieve stock portfolio diversification can only be effective if they are periodically reviewed and adjusted as required. This is because, with time, the risks associated with different categories of stocks in your portfolio may change. For instance, some sectors that were stable when you invested in them may become riskier with time. Or, some geographical regions that once offered poor investment options may now have more lucrative stocks to offer.

To ensure that the risk profile of your portfolio is optimised and to leverage potential opportunities for beneficial diversification, it is crucial to periodically review your investment portfolio as well as your diversification strategies. 

Conclusion 

With this, you may now have a better idea of what stock portfolio diversification is and why it matters. The tips outlined above can also help you understand how to build a sufficiently diversified stock portfolio. You can start with a few of the pointers and then proceed to incorporate more of these strategies in your equity investment plan.

The Motilal Oswal Research 360 platform can be helpful in this regard. You can access expert research reports and perform extensive analysis of different stocks to find the best additions to your investment portfolio. Sign up to this platform today to effectively diversify your investments and benefit from reduced risk.