Reasons to diversify your MF portfolio.
Investing in all asset classes and all categories of investments is not the right way to create your portfolio, especially if you’re starting with a small investment amount.
This causes a significant overlapping of assets and over-diversification, leading to reduced and inefficient returns in the portfolio.
How can you choose the right investment option that generates returns to help you meet your objectives with reasonable volatility? Do you want to know about the power of diversification?
What is diversification?
Diversification is the first and the most critical aspect of investing.
Diversification is an investment strategy that involves investing in a mix of instruments to reduce risks and maximize portfolio returns. Mutual funds provide the best form of diversification.
They offer exposure to multiple assets (stocks or debt) within a single fund. Moreover, there is a mutual fund for every investor with varying risk appetites and investment objectives.
Advantages of diversification
Diversification itself is one of the advantages of investing in Mutual funds. The main advantages of diversification are: –
- Minimize risk: Diversification in a portfolio reduces the overall risk of a portfolio. With proper diversification, there is a considerable reduction in the volatility of investment holdings.
- Creates a cushion: When diversified optimally, your portfolio can efficiently absorb significant, unpredictable market corrections without causing much loss to your portfolio.
- Better risk-adjusted returns: Diversification is not done to maximize risk solely. For example, if two portfolios generate the same percentage of returns, the diversified portfolio here takes less risk and has low volatility compared to the other portfolio.
- Compensating effect: The primary purpose of diversification is to prepare for all market conditions. So, when the market is highly volatile, in a well-diversified portfolio, even if one instrument has significant losses, the other instrument (for diversifying) would be chosen in such a way that it still generates returns to a certain extent to compensate for the losses incurred.
Additional read: Why you should geographically diversify your portfolio?
Why should you diversify?
The first rule of investing is that “you should not put all eggs in one basket, “ meaning you should not invest all your savings in one instrument.
The primary purpose of diversification is that if one investment instrument in your portfolio tanks, the other having a negative correlation may rise, thereby reducing the overall portfolio loss.
What are some common ways of diversification?
Asset allocation can happen in several ways. Some common strategies used for portfolio diversification are: –
1. Different asset classes
A portfolio should have a good balance between different asset classes as all would have a different impact when the market takes significant turns.
For example, to compensate for the volatility seen in equity investments, one can invest in debt-based instruments or gold to hedge market risks.
2. Different instruments
You can diversify into different instruments within the same asset class. While investing in equity mutual funds, you could choose between market cap funds like blue chip funds, mid-cap or small-cap funds, or even index funds for proper diversification.
3. International diversification
Geographical diversification also helps maximize the portfolio’s risk-adjusted returns. Investing in USD can take advantage of the currency movement and hedge over the currency risk.
Different and diverse. What is the difference?
One common mix-up investors get into is thinking that investing in different mutual funds is equivalent to diversifying. But different doesn’t necessarily mean diversifying.
Even if you invest in different funds, those funds may have the same or similar holdings. This causes overlapping of asset allocation in one portfolio. Diversification does not happen when a factor similarly affects the holdings of both funds.
Lastly, we’d say that holding a well-diversified portfolio is much better and more beneficial than just being invested in a single asset that is considered to be safe.
In the end, just investing and generating returns is not enough. You should ensure that whatever you’re saving is being optimally allocated so that your investments generate returns efficiently and effectively.
Also, do review your investments periodically to check whether or not they are in line with your goals and objectives.