Investment diversification is an effective technique for managing portfolio risk with respect to market-linked products like mutual fund schemes. However, many investors mistakenly assume that diversification means investing in various instruments without giving them any consideration, and as a result, they wind up with too many schemes. This makes it harder to manage the assets and reduces the portfolio's total return-generating capacity.
This blog will delve into the need for portfolio diversification and how to go about it strategically.
Need for Diversification in Mutual Funds Schemes
Market-related risks affect all assets, and they will almost certainly experience losses at some point. This can be seen in how the tech stocks collapsed when the dot-com bubble burst and when banking equities dropped during the subprime crisis.
By placing all your eggs in one basket, you take a significant risk that might jeopardize your financial goals. While diversity is commonly thought to lower overall risk, it may also offer you many possibilities that you would have otherwise overlooked.
Ways to Opt for Diversification in Mutual Funds Schemes
You may now be asking what your optimal amount of diversity is and how you may ensure that you have enough diversification while investing in mutual funds schemes. Here are a few pointers for building a well-diversified mutual fund portfolio that you'll probably find beneficial.
Maintain a Proper Balance while Allocating Funds to Various Schemes.
Investors' diversification needs may differ based on their age, risk tolerance, and expected returns. As a result, a youthful investor may want more diversification and stock exposure, whereas an individual nearing retirement may require more debt exposure.
Although the mutual fund schemes' exposure to a single asset class may be substantial, depending on the investor's age, the fund should be suitably dispersed among other schemes within that asset class. With changes in the investor's age and risk tolerance, the proportion of fund allocation to different asset classes should progressively evolve.
Ensure That Your Stock Holdings are Diverse.
When diversifying your portfolio, keep an eye on the stock holdings of the mutual fund schemes you have picked. If the stock holding pattern of two comparable mutual fund schemes is similar or identical, you should avoid them. When the market is turbulent, having the same stock holdings might sabotage your diversification efforts since they will have similar reactions. Investing in mutual fund schemes with different stock holdings can help you diversify your portfolio while reducing portfolio overlap and improving your risk-reward ratio.
Diversify Your Investments Across Time Frames.
You should also diversify your assets across multiple mutual fund schemes with varying time frames. In the short and long term, risk levels frequently fluctuate. It is easier to average out risk when you invest in two different mutual funds with distinct periods.
Invest in a Variety of Underlying Benchmarks.
Assume you put all of your money into mutual fund schemes that follow the same benchmark. In such instances, their performance is likely to be similar because the risk associated with their benchmark is the same. Instead, if you invest in several schemes with various underlying benchmarks, the risk associated with each benchmark will vary, and your investment portfolio will be more diversified.
Choose a Tax-Saving Mutual Fund, i.e., an ELSS Fund.
One of the most significant ways to diversify and avoid taxes is to start a Systematic Investment Plan (SIP) and invest every month in a tax-saving mutual fund or an Equity-Linked Savings Scheme (ELSS). Under Section 80C of the Income Tax Act, you can save up to Rs 1.5 lakhs as a tax deduction every year by investing in the best ELSS mutual funds.
Conclusion
Eventually, diversification is a continuous process that investors should pursue rather than a one-time exercise. Due to market volatility, portfolios might become skewed toward a single asset class; as a result, the investor must restructure the portfolio from time to time and diversify the investment in different mutual fund schemes appropriately. If investors cannot diversify their portfolios well on their own, they should seek help from a licensed financial advisor like the PGIM.
