Diversification and its Importance in Mutual Funds

One of the most basic and important tenets of investment planning is diversification, believed by many financial experts and financial advisors. Even though diversification brings down the risk of the investor’s portfolio, if not done in a calculated manner can prove disastrous. Often, some investors tend to continuously buy mutual funds impromptu believing that they are diversifying their portfolio. However, this is a bad idea unless done in an effective and planned manner and does not add much value to your portfolio.

Importance of Diversification/Asset Allocation:

An investor can choose asset categories that go up and down with various market conditions in a portfolio, in order to save himself/herself from significant losses. As the market conditions effects each asset category differently, it is wise to invest in more than one asset category so that fall in returns in one category can be counteracted with another asset’s better returns. Therefore, if the right set of investments are made, you can limit your losses and decrease the fluctuation on the investment returns without having to give up on potential gain.

Asset diversification is also important as it will play an important role in helping you achieve your financial goal. Including assets with risk is also important as it helps you achieve a large enough return. However, do not go overboard on taking risks as you may lose your money even before you can use it.

Process of Diversification:

Asset allocation or diversification of mutual funds largely depends on your risk appetite as well your time horizon. You can diversify your funds in the following ways:

  • Asset Classes – Since all assets do not have the same kind of return, it is important to have a distribution of asset classes in your portfolio. This helps you to avoid the risk of wealth erosion to your investment portfolio. For instance, when the equity market is turbulent, it is a good idea to invest in FDs(Fixed Deposits) and FMPs (Fixed Maturity Plans).

When you diversify across classes, it is important you keep account of factors such as income, expense, age of investor and financial goals. Some investors also follow a diversification model appropriate to your risk profile.

  • Time Horizons – Investors should hold multiple investment portfolios each catering to a different need over a proportionate time horizon. An investor can have short-term goals, medium-term goals as well as long-term goals. Each of these goals should have a particular portfolio associated with it and the investment should be aligned with the time horizons.
  • Investment Avenues – Apart from diversification of asset classes, there needs to be diversification in different investment avenues as well. You need to diversify appropriately between mutual funds and stocks. However, you must be careful that you do not over-diversify.
  • Issuer of Securities – Some investor invest in securities belonging to some specific issuers, for various reasons, sometimes irrational. It is important to keep in mind that investing is a serious affair and an investor cannot get emotional or illogical while choosing an issuer. Remember to invest across AMCs as each of them display a unique investment style.
  • Countries – RBI (Reserve Bank of India) has widened the scope of investment by allowing you to invest in assets across countries. Ensure you have full knowledge of the country’s economy before investing abroad. Also, keep in mind the tax implications it may occur so that it doesn’t nullify your returns.

Rebalancing your portfolio is crucial if you are considering diversification of funds. It involves re-alignment of the investment portfolio where you shift your risk-prone asset classes to safer asset classes as you move closer to your financial goal. 

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