In the mutual fund market, your portfolio is your ticket to successful investment. For earning lucrative returns consistently, fund advisors warn against putting all your eggs in one basket. This means it isn’t prudent to focus your entire portfolio on a single asset class or even fund type. This is where risk or portfolio diversification comes in.
It is the simple act of mitigating potential capital loss by choosing funds that invest in diverse stocks or securities. So, why is this an important process and how to do it correctly? Let’s find out.
Understanding risk diversification
The concept of portfolio diversification is easily comparable to a cricket team. A cricket team having all 11 of its players as batsmen or bowlers is unheard of. There’s always a mix of bowlers, fielders, and batsmen, depending upon the skillset of each player. Plus, this creates a vital balance needed to win a game that demands diverse skillsets, all working in harmony.
Similarly, each different fund type in your mutual fund portfolio also works in harmony to ensure that the risk does not exceed beyond your endurance capacity. For instance, if the equity market falls, the loss is compensated for through the stability offered by debt funds and other money market instruments. This will help you stay afloat till the equity market recovers.
Additional Read: What is the Right Time for Portfolio Rebalancing?
Risk diversification: Why it’s your saving grace
Here are the top reasons why risk diversification of your MF portfolio is not just an option but a necessity.
• It spreads out your risk evenly
Regardless of your risk profile, you must practice diversification as no investor is 100% immune to the sudden and volatile changes of the equity market. On the other hand, only investing in low-yielding debt funds will make you lose out on the opportunity for healthy returns. By spreading out your risks evenly, you will generate good returns at low-risk levels.
• It maximises your returns
Owning a concentrated portfolio can adversely affect your returns, especially when one asset class is performing poorly. At such times, you may be forced to sell units at a lower price since staying in the market would mean further losses. Via risk diversification, you can earn across various asset classes and at different periods of time, thereby generating higher returns.
Is there such a thing as over diversification?
Yes! If you’re not careful enough, you might end up with the problem of over-diversification, which makes it challenging to track fund performance (in every category) and increases your costs. Do you own too many mutual funds within a single category or notice that a single news flow has a disproportionate impact on the portfolio? If you answered yes to either of these questions, it is highly likely that you have over-diversified your portfolio.
Some ways to rectify this are to ensure that you purchase only 3 to 4 funds in every category, invest in different asset classes, and maintain diversification even within a fund type; for example, investing in small-cap and large-cap under equity funds.
Now that you know that diversification is not just a game of numbers, are you ready to select a mix of top-performing funds from different asset classes and categories? Build a solid MF portfolio with Tata Capital’s Moneyfy app! Find top picks of the day, personalised recommendations, and fund details to help you make an informed choice. Get started today!