Diversification in Mutual Funds

8 Mins

All of us have heard the famous saying “Don’t put all the eggs in one basket”. All the financial experts keep using this line every time they mention diversification. What is diversification? Simply put, it means spreading your investments across multiple asset classes so that your returns aren’t much affected by sudden volatility in the market. Most investors, including me, strongly believe that diversification can be achieved by investing in different investment products. But, investing in mutual funds can also diversify your portfolio in an ideal manner.

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Why Diversify?

The need of the hour is to diversify. Investments aren’t immune to market risk. A dip in the value can be seen in every market cycle. As much as there are new developments by the companies there are as many new scams unfolding in the market. Volatility in the market has led to higher highs and also lower lows. If one sector is performing well doesn’t mean the other does too.

Diversifying across categories gives you an edge when a category is underperforming. Diversification can help you reduce the risk of investing. It might not completely eliminate it, but can make your portfolio strong enough to face the volatile market.

Diversification with Mutual Funds

Ron Chernow rightly said mutual funds have historically offered safety and diversification. And they spare you the responsibility of picking individual stocks. Without in-depth knowledge of the asset class, you can spread your risk with diversification.

Equity, debt and balanced mutual funds can help you diversify your investments. Equity mutual funds invest in equity markets. There are multiple options available to you like the large, mid, small and multi-cap. Debt funds invest in various corporate bonds, government bonds, and money market instruments. They give a better return than traditional FDs. Balanced mutual funds are hybrid instruments of debt and equity. They strike a balance between the two asset classes. It’s like getting the best of both worlds. Avoid sector-specific and thematic funds if you have little to no knowledge about the sector.

How to Diversify Mutual Funds Portfolio?

To create a diversified mutual fund portfolio, you have to carefully choose funds and invest in different types of funds with holdings in diverse stocks or securities. The following are the points that you can consider to diversify your mutual fund portfolio –

Create Balance Between Different Schemes: It is always important to spread your investment across different securities because any failure in one particular security will not affect your entire portfolio or overall returns. For example, if you invest in two different funds provided by two different AMCs. However, if both the fund holdings are the same or underlying securities are the same, it will not help you minimize the risk. Therefore, while diversifying your mutual fund portfolio, you should carefully select schemes that invest in different securities like stocks, bonds, money market instruments, gold or any other asset class.
Create Diversification Across Different Horizons: You can choose to invest in different types of mutual funds like equity funds, debt funds or hybrid funds based on your financial objectives and time horizon. For example, if you are looking for higher capital gains in the long term, which is 5 to 10 years away from now, you can include equity funds in your portfolio. Similarly, if you want to plan for short-term goals with predictable returns, you can opt for debt funds. Also, it is important to diversify across different market capitalizations like the large, mid and small-cap while choosing equity schemes.
Role of Different AMCs: It is essential to choose funds across different AMCs as each AMC designs funds keeping certain investment objectives. However, the schemes may invest in the same asset class that other fund houses may have invested in. The investment objective may differ from one AMC to another. Therefore, diversifying across AMCs and different fund managers will help in minimizing risks during market volatility and optimizing returns.
Including Schemes Across Different Benchmarks: You can also try to include funds across different benchmarks. The fund manager decides on a benchmark based on the fund’s investment objective. It is a standard metric used to measure mutual fund performance. You can compare the scheme performance with its benchmark (e.g., Nifty 50, Bse 100, Bse midcap, CNX 100, etc.) from a short to a long-term period. Therefore, if a fund has delivered consistently higher returns than its benchmark index, it depicts a consistent fund performance. You can consider including these funds in your portfolio.

Therefore, mutual fund portfolio diversification is not about how many funds you invest in. It is about investing widely across asset classes and sectors based on your financial goals. Every financial goal must be linked with each mutual fund investment for better future planning.

Importance of Diversification to Investors

The following points highlight the importance of diversification for investors:

Lower Impact of Market Volatility

Diversifying across asset classes and sectors reduces overall risk and market volatility. When you invest in multiple funds, you reduce industry- and company-specific risks.

Explore Diverse Investments

Diversification balances the risk and returns associated with the various funds. For example, if you invest in mutual funds, you have access to debt, equity, gold, etc. When you invest in fixed deposits, you benefit from returns and a low level of risk. Thus, mutual funds allow you to reap diversification benefits by investing in different products.

High Risk and Low-Risk Investments

With mutual funds, you can invest across different categories. For example, you can choose to invest in high-risk mutual funds for your long-term goals. While, for short-term goals, you can invest in low-risk funds. Similarly, you can invest in debt schemes for stable and regular income. Thus, though some of your investments may be risky, you can balance the risk by investing in low-risk schemes. Therefore, your overall portfolio will not be highly sensitive to market volatility.

You may Alternate Investments

When you are investing across a single investment for an extended period of time, you must absorb the loss of the entire fund if it suffers a loss. Thus, it is a good strategy to rebalance and shuffle your portfolio to capitalize on market changes or when your goal is achieved. Spreading your investment among asset classes enhances annual returns.

It Provides Peace of Mind

Without question, it is one of the greatest advantages. When your overall investments are segmented among several asset classes, you need not worry about the performance of your portfolio. Market movements will not significantly impact your portfolio returns if it is well diversified.

Ideal Diversification or Over Diversification

Investment in how many funds can lead to ideal diversification? An ideal number of funds depends on the amount of investment, horizon, goals and risk appetite. A maximum of 5 mutual funds is considered ideal when it comes to equity mutual funds. These funds have to be spread across various market segments and fund management styles.

Investing in too many funds can make portfolio management difficult. Over diversifying can lead to lower returns. In over-diversification, you end up investing in similar sectors. It is always good to choose one to two schemes per category.

DIY (do it yourself) mutual fund investors are more prone to the risk of over-diversifying their portfolios. They consult multiple experts who end up giving similar recommendations. Leading to a portfolio which is invested in a few similar segments.

Is there any solution to this problem? Yes, consult a financial advisor who will help you with the ideal diversification. Online portals like Scripbox have developed an algorithm to help you choose funds. They pick up funds which have performed consistently over a period of time and not the chartbusters or dark horses.

Apart from taking help from an expert, there are a few steps that you need to follow too. Avoid getting excited by the market’s ups and downs. Give enough time for your investments to make the best out of the market conditions. Stop switching between funds in a short time span. This will only lead to an unmanageable portfolio. Choose a scheme that matches your investment requirements and best fits your risk appetite.

Keep in mind what John Neff said about diversification. “Obsession with broad diversification is the sure road to mediocrity.” Do not be mediocre when it comes to investments.

We at Scripbox are always ready to assist. Invest in mutual funds with Scripbox and get the right advice from our experts.