How to build a diversified mutual fund portfolio

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Updated: November 11, 2021 9:28 PM

Diversification does not mean investing in multiple instruments without thinking it through. Over-diversification also cuts down the portfolio’s overall return-generating potential.

mutual fund, mutual fund investment, debt fund, AMFI monthly data for October 2021, Liquid Fund, Short Duration Fund, Banking and PSU Fund, Corporate Bond Fund, Long Duration Fund, Gilt Fund, Floater fundsDiversification requirements mostly vary from investor to investor depending on his/her age, risk tolerance and return expectations.

When investing in market-linked products like mutual funds, diversification can be an extremely useful tool to manage portfolio risk.

Diversification, however, does not mean investing in multiple instruments without thinking it through. Investing in too many products and schemes could lead to over-diversification, and may become hard for the investor to manage all the investments. Experts say over-diversification also cuts down the portfolio’s overall return-generating potential.

Having said that, keep in mind there is no one ideal diversified portfolio, that ensures an adequate level of diversification for all, when investing in mutual funds. Diversification requirements usually vary from investor to investor depending on one’s age, risk tolerance and return expectations.

Here’s how you can build a diversified mutual fund portfolio:

1. Balance between different schemes when allocating funds
While a young investor might require diversification with higher exposure to equity schemes, an investor close to retirement may require higher exposure to debt schemes. Diversification requirements mostly vary from investor to investor depending on his/her age, risk tolerance and return expectations.

For instance exposure to a certain asset class may be high or low depending on the age of the investor, but even within that asset class, the fund should be adequately distributed to different schemes. If a young investor has 80 per cent of his portfolio invested in equity schemes and 20per cent in debt – out of the 80 per cent in equity schemes, the fund should ideally be allocated into different equity mutual funds covering small, mid, and large-cap funds as per the investor’s return expectations instead of allocating all into a single fund. The proportion, however, should gradually change with a change in the investor’s age and risk appetite.

2. Diversification across different time horizons
Industry experts say along with diversification across different schemes, an investor should also consider different time horizons to achieve a greater diversification level. This is because the risk levels usually change in the short and long term, hence, when invested in two schemes with different time horizons, it averages out the risk more efficiently.

3. Variation in stock holdings
Look at the stock holdings of the mutual fund schemes while diversifying your portfolio. Experts say while doing so one might find out two similar schemes in their stock holding pattern as same or identical and avoid them. Note that having the same stock holdings in multiple schemes can spoil the diversification plans. This is because such schemes will perform in the same way whenever the market is volatile.

4. Role of different AMCs
If you invest in mutual funds through different asset management companies (AMCs) and different fund managers, it will allow you to better average out their performance, in case of market volatility.

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