Mutual funds have been rising in popularity as the preferred choice for investors to meet their future goals. However, to make the most of the benefits of mutual funds, an efficient and well-diversified portfolio is needed. Here is a guide on how to build a diversified mutual fund portfolio.
Diversification within asset class
Also known as horizontal diversification, it involves diversification of mutual funds within the asset class of equity, fixed income (debt), gold, metals/real assets, real estate, etc. This helps in spreading the risk and your money amongst various types of securities included in a particular asset class. For instance, if you are holding equity funds, you may diversify it through investment in a combination of mid-cap and large cap funds. Diversification within an asset class reduces the risk associated while holding a single type of security and helps to absorb the fluctuations in case any particular type of security isn’t performing well.
Diversification across asset class
Also known as vertical diversification, this involves diversification across different asset classes. If you are holding equity funds then you should also invest in fixed income securities (debt) for diversification across asset class, and vice versa if you currently hold fixed income asset class including debt funds, PPF, EPF, etc. The major benefit of diversifying across asset classes is that if one asset class performs poorly, the other asset class can provide cushion to absorb that loss. For example, if you invested `2 lakh in equity funds and the stock market suddenly undergoes a sharp correction, you may have to incur severe losses. However, if you have diversified your portfolio by investing in other asset classes such as bonds, the overall impact of loss on the portfolio would reduce. Various asset classes such as equity, debt, gold, metals, real estate, etc., involve a negative correlation amongst themselves, implying that when the price of one goes up, the other goes down. Example of negative correlation amongst asset classes includes equity with gold, equity with debt, etc. Using negatively correlated investments in portfolio helps in reducing the overall volatility and diversifies the risk factor of portfolio.
Another way of diversifying your portfolio is through geographical diversification, which involves diversification of portfolio across different geographic regions or different countries. Most investors opt for this type of diversification to reduce overall risk and improve returns on their portfolio since this diversification involves investment in different financial markets in the world which aren’t closely correlated and therefore, changes in one’s prices won’t necessarily reflect on other market.
Fund manager diversification
Since different fund houses have different fund managers managing the investor’s money, it is quite possible for a fund manager to make mistakes or perhaps his management style doesn’t suit the investor’s interests. In such cases, rather than changing your fund house frequently in order to find one right fund manager, it’s advisable to diversify portfolio by investing in multiple fund houses.
Investment style diversification
Various investors have different investment styles according to their risk appetite, investment horizon, financial goal, etc. However, an investor can build a diversified portfolio containing different styles of investment, such as growth, dividend or value. Each investment style serves some particular purposes and a portfolio having a set of differently styled investments leads to fulfillment of various goals.
For instance, growth investing looks for companies having high potential for growth as compared to others, without being overly concerned regarding its current market price of the stock. Whereas, value investing involves investment in under-valued stocks which have scope for appreciation, such as the stocks of a financially strong company going through a bad business cycle. Therefore, picking multiple investments involving different investment styles diversifies investor’s portfolio by providing varying fund management approaches.
Diversify but don’t duplicate
While investing in mutual funds, many investors consider duplication as diversification. That’s the first mistake which leads to formation of an inappropriate portfolio. Diversification is investing your money in different asset classes or in different types of securities within an asset class to reduce risk. But, duplication is when a portfolio contains similar type of securities which doesn’t offer anything different to the investor, doesn’t reduce the overall risk and the returns also continue to remain average.
By Manish Kothari
The writer is director & head of mutual funds, Paisabazaar.com