Many investors, whether new or existing, put in their hard earned money into mutual funds to fulfill the aim of wealth creation and ultimately, to achieve the set financial goals of their respective lives. The key to achieving all your goals lies in creating and maintaining an optimal investment portfolio consisting of diversified mutual fund investments. This is exactly where asset allocation comes to one’s rescue. Not only does it assist in selecting diversified mutual funds for ensuring timely achievement of varying life goals but also enables the investor to hold a balanced and stable portfolio to tackle the market and economy’s ups and downs.
Let us understand the importance of diversification of mutual fund portfolio, how to do it, and how it can act as a catalyst in successfully achieving all your financial goals:
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Understanding MF portfolio diversification and why its important
We have all heard the adage ‘never put all your eggs in one basket’. This holds especially true for investors. Solely relying on just one mutual fund or asset class can put you in trouble during economic fluctuations, at worst leading to capital erosion and incurring of losses on your hard earned money which was put in as investment.
In the whole gamut of MF investment portfolio creation, they key to achieve the twin goals of maximising returns and minimising risk becomes possible only through diversification of your MF investment portfolio. Besides assisting in balancing the primary aspect of risk-reward component of portfolio, diversification also factors in other aspects such as the investment horizon and earmarked financial goals associated with the set goals.
Moreover, even post creation of a diversified portfolio, it’s always prudent and equally important for investors to not restrict this task of portfolio creation as just a one time activity, and go ahead to develop the habit of reviewing the portfolio’s asset allocation and making the required adjustments time to time, as per changes in risk appetite, investment horizon, financial goals and/or under-performance of the chosen fund (s).
Hence, by sliding in a level of diversification into your mutual fund portfolio through adoption of an appropriate asset allocation strategy, investors can fulfill not one but multiple objectives such as- strike a balance between risk-reward, address varying liquidity requirements, portfolio re-balancing on need basis, and last but not the least, remain well-positioned amidst varying market phases. Simply put, asset allocation is the process of distributing an individual’s investments across various asset classes, such as equity, debt, gold, cash, etc., according to his/her risk appetite and the investment horizon for different financial goals.
As far as financial goals are concerned, portfolio diversification would assist in timely achievement of each of the goals as per the varying investment horizons associated with them. Whereas on the flip side, failure to diversify can pose a risk of not being able to achieve the set goals and their target corpuses on time, due to the primary reason of underperformance of the chosen asset class/fund upon which the investor had solely relied upon. This is exactly where diversification acts as hedging and balances your portfolio to facilitate the achievement of set goals. For instance, to achieve short term goals involving horizon of 1-2 years, investors can hold debt funds in their portfolio, whereas for long term ones spanning above 5 years, equity funds would be a suitable investment avenue in one’s MF portfolio.
Why and how to go for asset allocation
When it comes to investment planning, especially over the long term, asset allocation tends to have a bigger impact on an investment portfolio’s returns, vis-a-vis the market timing and security selection. Failure to have an appropriate asset allocation strategy in place, investors often end up getting their investment decisions influenced and based on the asset’s current performance and popular market trends. As different asset classes perform differently in varying market market situations and economic cycles, it becomes imperative for those holding a portfolio in entirely one asset class, especially a highly volatile one like equities, to diversify the investment portfolio and balance risk-reward component by adding debt investments.
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Here are the key benefits of diversifying your MF portfolio:
Helps to generate optimal returns on portfolio
All asset classes have their own distinctive features. Some may score high on returns while others might score better in terms of income certainty and capital protection. For instance, equities can be very volatile in the short term but they hold the potential to yield higher returns than almost all asset classes over the long term. Whereas on the other hand, fixed income securities tend to offer higher income certainty as well as capital protection but underperform equities over the long term. Hence, in a diversified portfolio consisting of both debt and equity MF investments, the equity component will lead to yielding higher returns over the long term whereas the debt component would provide the required stability to the MF portfolio during phases of increased volatility in the equity market in the short term.
Minimises overall risk in your portfolio
Some asset classes tend to have negative correlation as far as generating returns is concerned. Dynamic market conditions can lead an asset class to register strong gains while at the same time denting the value of another asset class to a great extent. Hence, to tackle such scenarios, diversifying your investments across asset classes with negative co-relation can offset the losses from a falling asset class through the gained appreciation from an appreciating asset class. For example, equities and fixed income instruments often have negative co-relation. Hence, during an economic decline, if you have both debt and equities in your portfolio, the losses from your equity investments are likely to be counterbalanced by the capital appreciation of your debt constituents.
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Provides adequate degree of liquidity
Liquidity is one of the primary factors investors consider while making MF investments. It refers to the ease at which investors can convert their investment into cash, whenever required. Following an appropriate asset allocation strategy will allow you to maintain enough degree of liquidity in your MF portfolio by parking a portion of your investment in relatively safer and liquid asset classes like debt funds. How to diversify mutual fund portfolio.
How to diversify your MF portfolio- 3 common types of diversification strategies
1. Diversification within asset class
This form of diversification involves investing in different categories of mutual funds within the asset class of equity and debt. This assists in spreading your invested money amongst various kinds of securities included in the chosen asset class. For instance, those holding equity funds can diversify the portfolio through investment in a combination of small cap, mid-cap and large cap funds. Such form of diversification within an asset class also 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.
2. Diversification across asset class
This involves diversification across different asset classes. Those holding equity funds can diversify their portfolio by also investing in debt or hybrid funds, and vice versa. The major benefit of diversifying across asset classes is that if one asset class underperforms, the other asset class can provide cushion to absorb that loss through its appreciation of returns, just like in case of the negative correlation of debt and equity.
3. Geographical diversification
Another way of diversifying your MF portfolio is through geographical diversification, which involves investment 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 it involves investment in different financial markets of the world which aren’t closely correlated and therefore, changes in one’s prices won’t necessarily reflect on other markets.
Key mistake to avoid when diversifying MF portfolio
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A commonly committed mistake amongst many investors who attempt to diversify their MF portfolio, is duplication of investments. When diversification is mistaken as duplication, it leads to formation of an inappropriate portfolio. While diversification implies investing your money in different asset classes or in different types of securities within an asset class to reduce the overall portfolio risk, duplication refers to the action of creating a portfolio involving similar type of securities/funds/asset classes which don’t offer anything different to the investor, fail to reduce the overall risk and the returns also continue to remain sub-optimal.
That’s why it’s important for investors to focus on the aim to diversify but not duplicate, as the former is not about the number of funds held in portfolio, but about investing efficiently for diversification across various asset classes, sectors, etc. through mutual funds investments.
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