Optimum Diversification of Your Mutual Fund Portfolio

A mutual fund invests pooled money in bonds, stock, and other asset classes to generate returns for its investors. Hence there may be different types of funds such as equity funds, debt funds, hybrid funds, etc. based on the asset class they are investing with.When you add a variety of such funds in your portfolio to balance out the risk factors and generate better returns, it is referred to as diversification of mutual fund portfolio .At the same time, you must refrain from blindly adding funds to your portfolio and must keep it optimally diversified. The diversification helps you to optimise your returns, but the benefits may become stagnant if the portfolio is overly diversified.

A diversified portfolio ensures that your money is invested across different sectors or industries that are unrelated. Hence, at a given point in time, it is likely that if some of the funds are underperforming, the other funds in your portfolio may be generating good returns, thereby balancing the losses. Let us understand this with an example.Kiran wishes to invest a sum of Rs 50,000 in mutual funds. If Kiran invests the entire money with a single fund (say an equity fund), his profitability will depend entirely on its performance. On the other hand, if he chooses to invest Rs. 15,000 in a debt fund and the remaining 35000 in an equity fund, the returns may be more stabilised since the debt funds are relatively immune from the market volatility.Hence, the risk has been lessened in the latter case.

1. Risk Mitigation Diversification prevents you from concentrating your capital under a single fund. Hence the risk of losses from poor-performing funds is balanced out by profits generated from high-performing funds in the same portfolio.
2. Balancing Risk-Factors and Profit-Generation Capacity Some funds are subjected to a higher market risk such as equity funds. Other funds such as the debt funds are comparatively safe and likely to generate stable returns. Different funds have their pros and cons but under the same portfolio, their shortcomings can be balanced for a better output.

The idea behind diversification is to invest across categories of asset classes to mitigate the overall risk and enhance the profit margins. But if you have bought multiple funds focussed on a single asset class, the benefits of diversification may be limited beyond a certain point.Also, you must be careful to invest in funds dealing with unrelated assets. For example, let's say you buy two funds that invest in the real estate sector and the cement industry separately. Since the cement industry is largely driven by the real estate sector, a single market movement or change in economy linked to any of these sectors can adversely affect both the funds.Apart from these issues, an over-diversified portfolio is cumbersome to track and manage. Also, every fund comes with brokerage and other expenses that may add up to a huge cost if you add too many funds to your portfolio.

It is crucial to optimally diversify your mutual fund portfolio to obtain the maximum benefits of diversification. You must consider the below points to make up your portfolio, the right way:

• Figure out the diverse categories of funds, you wish to invest in These categories may be chosen as per the asset classes, industries/sectors, or strategy of investment adopted by the funds. Make sure to pick unrelated funds with good performance history.
• Ensure a balanced investment in each category Though it may depend on other factors like your investment objective, ideally it must not be too high or too low in a single category of funds. For example, investing 90% of the corpus in equity funds can increase your risk significantly. Similarly, investing a large portion of your money in debt funds can decrease the risk factor, but the returns may be lower as compared to equity funds. Hence you must try to strike a balance that works best for you.
• You must pick diverse funds within the same category of funds too For example, under debt funds, you may invest in short-term funds, liquid funds, etc. Similarly, under equity funds, you may spread your investment across ELSS, Small-cap, large-cap funds, etc. A good diversity within a single category is desirable for a robust portfolio.

You must understand that the idea behind diversification is investing in a variety of financial instruments across asset classes and industries. Rather than focusing on the number of funds in your portfolio, you must ensure that they are from diverse and unrelated domains.Also, remember that diversification can help you lower the associated risk, but it cannot be completely eradicated. Hence, keep limited but diverse funds in your portfolio so that you can easily monitor their performance. Also, you may opt-out of any fund and pick another, if the performance is consistently poor and there are no chances of revival.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.