Diversification is one of the most common terms used with respect to investments. The most straightforward example to understand diversification is by suing the example of a cricket team. A cricket team will never have only batsmen or bowlers as all eleven players. In fact, even the batsmen and bowlers within the team will be of different types. This is because a team requires different skill sets to perform well.
Similarly, when it comes to investments, diversification is the ideal method to mitigate risks and allow your portfolio to perform better. Most investors believe in asset allocation across different categories to achieve diversification. While that is one way to look at it, investing in mutual funds can diversify your portfolio in an ideal manner.
The need to diversify
No investments are immune to market-related risks and will most probably see some amount of fall at some point in time. Over the years, we have seen tech stocks fall when the dot-com bubble burst and financial stocks fall during the subprime crisis. Even the growth of real estate investments has seen a considerable stagnation in the past few years. It is a huge risk to put all your eggs in one basket, one that can even lead to disruption of your investment goals.
While diversification is seen as a method to reduce your overall risk, it can also provide you with multiple opportunities that you may have otherwise neglected. You inadvertently invest in asset classes that you are not even comfortable in investing. However, what if you do not have the financial bandwidth or knowledge to diversify your portfolio?
Diversification with mutual funds
Mutual funds are the easiest way to achieve diversification as well as asset allocation without in-depth knowledge of each asset class. By investing in mutual funds that invest in different asset classes such as equity, debt, and gold, you can spread your risks. A sudden change in any macroeconomic condition will not change your portfolio value drastically. So, which mutual funds should you target to diversify your investment?
Equity mutual funds: These funds make investments in the equity market. There are multiple options available that may suit your investment goals and risk appetite. You can go for any one or a combination of large-cap, mid-cap, small-cap and multi-cap funds. By analysing the portfolio of the equity fund, you can ensure that the scheme you choose invests across industries and asset classes.
Debt mutual funds: These funds invest in a mix of debt securities such as corporate bonds, money market instruments, treasury bills, etc. While offering higher liquidity than traditional FDs, debt mutual funds can even yield higher returns over an extended period of time. Debt mutual funds are also more tax-efficient, especially when the holding period is greater than 3 years thanks to the benefit of indexation.
Balanced mutual funds: These are hybrid mutual funds that invest in equity as well as debt. Balanced funds are ideal investments for novice investors who don’t want to take on equity-related risks. These funds provide the cushion that comes with fixed income instruments and are the simplest way to diversify.
How many funds can ensure diversification?
This is one of the most common problems faced by investors who understand the importance of diversification. The ideal number of funds depends on factors like your investable amount, investment goals and risk profile. For equity mutual funds, you should not have more than 3-5 funds in your portfolio which are spread across different market segments and fund management styles.
Investing in a higher number of funds will impair your capability to monitor the funds effectively. Besides, it may also result in repetition of stocks affecting the very basis of diversification. It is worth remembering that diversification is not about numbers, but investing across a range of companies, sectors and assets classes by using mutual funds as the instrument.