How Mutual Fund Diversification Helps Build a Balanced Portfolio

Investors can leverage mutual fund diversification to invest in various securities, industries, companies and assets. Instead of investing in a few selected securities, investors can rely on mutual funds to invest in more diverse investments via one mutual fund. Nevertheless, having many mutual funds does not guarantee that the investor will be diversified. The investor must look into the components, objectives and similarity among funds.

What is Portfolio Diversification?

Portfolio diversification is the practice of spreading investments across various asset classes. This helps reduce the risk associated with individual securities. Mutual funds can be a powerful tool in achieving this. By investing in different securities, mutual funds allow investors to reduce their exposure to market volatility.

A diversified portfolio is designed to balance risk and return by allocating investments in stocks, bonds, and other assets. In case one investment performs poorly, others may perform better, balancing out the overall performance.

How Mutual Funds Provide Built-In Diversification

Mutual funds pool funds from various investors and invest them in securities according to the investment objectives of the fund. Based on the nature of the mutual fund, the investments made could be a combination of shares of various listed companies, bonds, government securities or any other investment type that is eligible for investment.

For instance, an equity mutual fund could make investments in firms belonging to various sectors. Therefore, an investor investing in the mutual fund will be able to invest in multiple securities without having to buy them individually.

The level of diversification could depend on the investment style of the mutual fund. For example, a mutual fund focused on one specific sector would have less diversification than a diversified equity mutual fund.

Advantages of Utilising Mutual Funds for Diversification

Here are some benefits of mutual funds for diversification of a portfolio:

1. Small Investment Amounts

The advantage of investing in mutual funds is that you don't require a lot of capital to start. You can invest as little as Rs. 500 in a systematic investment plan (SIP) in India, thus making it accessible to the investor with limited capital.

2. Professional Management

Mutual funds are managed by professional fund managers who use their expertise to make informed investment decisions and adjust holdings based on market conditions and goals. This professional management is ideal for investors who lack the time or knowledge to manage their investments effectively.

3. Liquidity

Mutual funds offer reasonable liquidity. You can redeem your investment if you need it. It makes mutual funds a reliable source of investment for those who wish to grow their capital and still want access to their funds easily.

4. Diversification Across Multiple Sectors

Diversification helps in gaining exposure to several sectors of the economy. For example, equity funds invest in the stock of companies from technology, healthcare, finance, consumer goods, etc. Thus, this helps in reducing sector-specific risks in your portfolio.

5. Daily NAV Updates

Mutual fund Net Asset Values (NAVs) are calculated daily. This helps in tracking the investments along with the return earned in an investment over time. The holding portfolio is updated every month, which enhances transparency levels and informs investors about the investments made.

Risks of Over-Diversification in Mutual Funds

Diversification can become less useful when an investor holds too many funds with similar portfolios. This is known as over-diversification or unnecessary diversification.

Some common concerns include:

• Overlap in portfolios: Various mutual funds may have several similar stocks in their portfolio.
• Difficulties in keeping an eye on them: It may become difficult to monitor the portfolio performance and changes when there are many funds in the portfolio.
• Inefficiency: Having many funds may lead to unnecessary complexity.
• Increased expenses: Depending on the choice of funds, investing in too many schemes increases the cost of the portfolio.
• Unclear allocation: Too many funds make it hard to understand how the assets and sectors are allocated in the portfolio.

Thus, it is wrong to take the number of mutual funds as the only criterion of diversification; investments in the funds as well as the goals of the fund should be considered.

How Many Mutual Funds Should You Hold?

There is no specific number of mutual funds that would be appropriate for each person. The right number of mutual funds varies from one individual to another, depending on various factors.

Before adding another fund, investors can compare its holdings and investment strategy with existing funds to determine whether it adds a different type of exposure.

Strategies for Building a Diversified Mutual Fund Portfolio

The following options may be considered by investors while creating a diversified portfolio of mutual funds:

• Diversification among different types of suitable funds: Investors can choose between equity, debt, or hybrid funds according to their investment needs.
• Consider the exposure to the sectors: Investors can see if the portfolio is concentrated in any particular sector.
• Check overlapping in holdings: By comparing the major holdings of different funds, investors can find out overlapping.
• Consider different investment strategies: Different investment strategies can be adopted in suitable equity funds, wherever needed.
• Portfolio review from time to time: Change in holding pattern of funds and investment needs may affect diversification in the portfolio.
• Diversification must be according to the requirements of the investor rather than adding more number of schemes.

Types of Mutual Funds to Diversify Your Portfolio

Different mutual fund categories provide different types of exposure. Investors can consider categories based on their financial objectives and risk tolerance.

The suitability of a category depends on factors such as risk appetite, investment horizon and financial goals.

How to Choose the Right Mutual Fund for Your Portfolio?

Choosing a mutual fund that is good for your portfolio depends mainly on your investment goals, risk tolerance and time horizon. Here are some criteria to consider:

1. Risk Appetite

If you are a conservative investor with a low-risk appetite, debt funds and hybrid funds will suit you better. They are more stable and less volatile. However, if you are a risk-taker and want growth in the long term, equity funds may be better for bigger returns.

2. Time Horizon

Your investment horizon is another essential factor in selecting mutual funds. A longer horizon may be able to accommodate the riskier options, such as equity funds. Conversely, debt funds would be suited to those seeking short-term returns with relatively lower risks and stable incomes over a smaller period.

3. Investment Goals

The financial goals will decide the mutual funds you would choose. If you are looking for capital preservation and regular income, then debt funds would be suitable. If you are looking for long-term capital growth, then equity funds or hybrid funds would be more suitable. Knowing your goals helps you choose the most suitable investment strategy for your needs.

4. Expertise of the Fund Manager

While selecting a mutual fund, one needs to consider both the experience of the fund manager and the performance. A qualified manager can guide you through volatile markets, making efficient decisions that help you achieve better returns. Their skills may influence the performance of the funds and your investment results in the long run.

Conclusion

Diversification is one way mutual funds can help diversify investors' holdings across various asset classes, sectors and securities. There may already be diversification within a fund's underlying holdings, and when complementary funds are combined, there may be more diversification as needed. But having too many funds with identical holdings could result in needless duplication. Once investors have determined their investment goals, risk tolerance, time horizon and existing portfolio, they can then plan their mutual fund investments effectively.