If your portfolio consists of equity funds which have similar stock holdings, then it amounts to just duplication and may negate the positive effects of diversification.
What is diversification?
Mutual fund investors diversify their portfolio across asset classes in order to reduce the overall risk. Here, the focus is more on eliminating the firm-related risk (unsystematic risk) while ensuring that returns are generated on expected lines. Thus, the assets are combined in such a fashion which ensures ease of management along with reduction of portfolio risk as well as cost of investment. The basic premise is not to concentrate all your resources in one asset class but to divide in amongst a variety of asset classes. In such a scenario, the positive effect of growth in other asset classes will offset the negative effects of downfall in one asset class. However, you cannot diversify market-risk i.e. the systematic risk. It still remains in the portfolio and can be managed by rebalancing the portfolio at regular intervals.
Mutual funds offer you the advantage of diversification at a very nominal initial investment. Each scheme is managed by an experienced fund manager who keeps track of the market movements and aligns the assets in your portfolio accordingly to ensure wealth creation.
How do mutual funds offer portfolio diversification?
In case of market-linked investments, continuous changes in the stock markets and the overall economy might affect the fund value. This may be in the form of extreme fluctuations or a fall in the fund value. Especially, during a market slump, portfolios tend to go in red which may result in loss of returns. Diversification offered by mutual funds helps to reduce such occurrences. It is believed that different assets will move up and down at different times. So, when negatively-correlated assets are combined in a portfolio, a fall in price of one asset would be compensated by a rise in the price of another asset. Basically, correlation shows the relationship between two asset classes and reflects their movement during a market phase. In this way, the overall portfolio returns may remain on the expected lines leading to wealth accumulation.
In case of equity funds, diversification would mean investing in stocks across industries/sectors and market capitalisation. In case of debt funds, diversification would involve investing in securities which mature at different dates so as to prevent a default due to asset-liability mismatch. Additionally, the fund manager may pick high-rated securities which have low sensitivity to interest rate fluctuations.
Things to keep in mind while portfolio diversification
Don’t invest in too many funds
If you stock your portfolio with say too many equity funds, then it does not amount to diversification. On the face, your portfolio may seem really diversified but it might just be the opposite within. Each equity fund is composed of a given number of stocks. If your portfolio consists of equity funds which have similar stock holdings, then it amounts to just duplication and may negate the positive effects of diversification. Instead of reducing risk, it will only increase the manageability problems. So, tone down to say 7-9 funds in your portfolio.
Avoid stuffing your portfolio with poor funds
It is important to be aware that whichever fund resides in your portfolio should serve your financial goal. Investors may commit a mistake of stuffing the portfolio with inferior funds. An inferior fund is one which has been performing poorly in a consistent manner and has lost more money during a market downfall. Keeping such funds in the name of diversification may be adding to your overall cost of investment (by way of expense ratio) without boosting your returns. Thus, it is very essential to track performance of your funds from the standpoint of risk, cost and expected returns. When a fund is not meeting your expectations, it’s better to part ways.
Stay away from concentrated bets
Many a times investors’ portfolios may suffer from concentration risk without them being aware of it. Concentration risk arises when a portfolio is excessively invested in one sector or a specific industry or specific category of funds. Consider a mutual fund portfolio which is composed of 9 funds namely 1 large-cap fund, 1 mid-cap fund, 2 small-cap funds, 2 technology funds, 2 banking funds and 1 pharma fund. At first look you may think that it is a well-diversified portfolio having manageable number of funds. But a revisit would reveal the discrepancies. Firstly, it is an extremely risky portfolio (due to around 33% exposure in mid and small-cap funds) and secondly, it has concentrated sector bets (i.e. around 55% exposure to sector funds).
Ideally, you need to have a limited exposure to sector funds because these are extremely risky bets. Here, the investor needs to increase his exposure to large-cap funds to say 60%, around 30%-35% may be spread across mid and small-caps and around 5% may be allocated to sector funds. However, you need to keep your risk tolerance and financial goals in mind before making any decision.
Look for geographical diversification and across company sizes
You may diversify your portfolio across company sizes. To avoid the stress of arriving at the perfect numbers, you may invest in multi-cap equity funds. In this, the fund manager invests across companies of different market capitalisations with emphasis on portfolio stability and wealth creation. Multi-cap funds like Equity-Linked Savings Scheme (ELSS) not only give higher returns but also help in tax-saving. Apart from this, you may also look for geographical diversification by investing in international equity funds. These funds invest in equity and equity-related securities of companies which are listed in recognised stock exchanges abroad.The Writer is Founder & CEO ClearTax