Investing in too many instruments could not just make it difficult to manage all the investments but also suppress the portfolio’s overall return-generating potential.
Risk management is crucial when you invest your hard-earned money in any of the investment avenues available in the market. When managing investment risk, you should know your actual risk tolerance, your returns expectations that can help fulfil your financial goals on time and whether the risk in your investments justifies the returns they offer.
Investment diversification can be an extremely useful tool to manage portfolio risk, especially when you invest in market-linked products like mutual funds. However, many investors wrongly believe that diversification is nothing but investing in multiple instruments without putting much thought and they end up investing in too many products and schemes. Investing in too many instruments is what is called over-diversification, which could not just make it difficult to manage all the investments but also suppress the portfolio’s overall return-generating potential.
Now, you might be wondering what would be your ideal diversification level and how can you ensure an adequate level of diversification when investing in mutual funds? I’ve discussed a few tips to build an optimally diversified mutual fund portfolio which you’re likely to find useful.
1. Try to maintain the correct balance when allocating fund in different schemes
Diversification requirements may vary from investor to investor depending on their age, risk-taking ability and returns expectations. So, a young investor may require diversification with greater exposure to equity schemes whereas an investor close to retirement may require greater exposure to debt schemes. Exposure to a particular asset class may be high depending on the age of the investor, but within that asset class, the fund should be adequately distributed to different schemes. Let’s suppose you are a young investor with 80% of your portfolio invested in equity schemes and 20% into debt. Now, out of 80% in equity schemes, the fund should ideally be allocated into different equity mutual funds covering small, mid, and large-cap funds as per your return expectations instead of having complete fund allocation into a single fund. The proportion of fund allocation to different asset classes should gradually change with change in the investor’s age and risk appetite.
2. Ensure variation in stock holdings
While diversifying your portfolio, you should also closely look at the stock holdings of your chosen mutual fund schemes. You may want to avoid two similar schemes if their stock holding pattern is the same or identical. The same stock holdings in multiple schemes can spoil your diversification plans as such schemes will result in the same reaction whenever the market is volatile. Investing in schemes with dissimilar stock holdings can allow you better diversification with low portfolio overlap and improve the risk-reward ratio too.
3. Choose different AMCs
Let’s suppose you invest all your money in the mutual fund schemes with the same asset management company and the fund manager. In that case, your investment portfolio’s risk-reward ratio may flatten because every time the fund manager’s approach to a particular situation would be the same. On the other hand, if you invest in mutual funds through different AMCs and different fund managers, it might allow you to better average out their performance when the market turns volatile.
4. Investments should be diversified across different time horizons
Your investments should also be diversified across different schemes and with different time horizons to achieve a greater diversification level. The risk levels usually change in the short and long-term. When you invest in two schemes with different time horizons, it helps to average out the risk more efficiently.
5. Diversify across different underlying benchmarks
Suppose you invest all your money in mutual fund schemes which have the same underlying benchmark. In that case, there are chances that their performance will be similar to each other as the risk associated with their benchmark would be the same. Instead, if you invest in different mutual fund schemes with different underlying benchmarks like CNX 50, BSE 100, etc., the risk associated with such benchmarks will vary and your investment portfolio will get diversified in a better way.
In conclusion, diversification is not a one-time practice but a constant process that investors should follow. Sometimes portfolios get skewed towards a particular asset class due to market volatility; therefore, the investor needs to rebalance the portfolio from time to time, and while doing that, it is crucial to diversify the investment properly. Investors would be well-advised to seek assistance from a certified investment advisor if they are unable to optimally diversify their portfolios on their own.
(The author is CEO, BankBazaar.com)