Portfolio Diversification & Its Benefits

"Never put all your eggs in one basket". 

Achieving a balance between risk and return is crucial when making investment decisions. Diversification is a key strategy for achieving this balance, as it allows you to spread your investments across different asset classes and sectors, reducing your exposure to any one particular risk. 

In this article, we will look into what portfolio diversification is, especially related to mutual funds, and how it can help you achieve the returns on investment that you are looking for. 

What is Portfolio Diversification?
When you go out for dinner, you often order a well-rounded meal for maximum satisfaction. You may order a soup, an appetiser, a main course, a dessert, and perhaps some drinks. This ensures that you get a variety of flavours and textures. Also, if one course is not satisfying, there is a chance that another course can make up for its flavourlessness. 

Think of portfolio diversification in a similar manner. Portfolio diversification involves investing in a variety of instruments for better risk-adjusted returns, i.e. reduce risk and maximise returns.  It involves spreading your investments across asset classes like stocks, bonds, commodities, real estate, and other alternative investments. Instead of directly buying in multiple markets like equity, debt, commodities, you can invest in all markets through a single Mutual Fund Scheme. 

For instance, Multi Asset Allocation Funds invest in a minimum of three asset classes with each class allocated at least 10%. Similarly, Multi-Cap Funds allocate a minimum of 65% of their investments to equity and equity-related instruments across stocks from various sectors and market segments. This diversification helps reduce the risk associated with having excessive exposure to a small number of stocks, sectors, or segments.

Moreover, you can invest in different mutual fund schemes for different goals. For instance, you may invest in debt funds for short-term goals, equity funds for long-term goals and hybrid funds for medium-term goals.

Each of these funds come with their own benefits and have a certain amount of risk that they carry. When you invest in a variety of mutual funds, specific to your goals, you can mitigate the risk to your overall portfolio. 

Diversification can also provide the opportunity to gain from different market areas, which helps maximise returns while minimising risk

Among mutual funds itself, there are certain categories of mutual funds that provide inherent diversification. For instance, multi-cap funds invest in small-cap, mid-cap and large-cap companies across different sectors and industries. Investing in multi-cap funds can help you get access to a wide range of company equities. Similarly, if you want a risk-balanced mutual fund investment, you could invest in a hybrid fund that invests equally in debt and equity investments. 

However, do remember that diversification neither guarantees success nor provides loss protection. Consider the investment objectives of mutual fund schemes before making investment decisions.

What Are The Benefits Of Portfolio Diversification?

1) Risk Management
When you diversify your portfolio, you ensure that if one asset class underperforms, other assets may compensate. Not all assets perform equally, and diversification allows you to reduce your risk. For instance, if equities underperform, debt instruments and gold will typically perform better. If you invest in a diversified mutual fund or have a portfolio that includes mutual fund investments across different assets, then your overall risk and returns will be balanced out. 

2)  Protection Against Market Volatility
A diverse portfolio lowers the overall risk of the portfolio. The total impact of market volatility is reduced due to investment diversification across asset classes and industries. Higher volatility in returns implies a riskier asset, and because of this, returns on risky assets are usually higher than returns on assets with lower risk. For instance, if you invest in equities and bonds of the same company, the return on investment in equities will be higher than return on investment on bonds. Risk in equities will also be higher. When you include both debt and equity in your portfolio, you ensure that the positive returns from one asset class could possibly compensate for lower or negative returns from another asset class. 

3) Goals
Diversification may help you attain specific financial goals. The objectives may change over time; achieving them may require flexible investing strategies. For instance, say you want to take yearly holidays, save for retirement, and pay your child's college expenses, you may need different mutual fund investments depending on the objective and the time horizon that will help you plan for each of these goals. If in doubt, consult your financial adviser. 

4) Long-Term Performance
Over the long term, a well-diversified portfolio may have the potential to provide a stable investment experience and may be better positioned to withstand market volatility.

5) Time Saving and Convenient 
Diversified portfolios can also help you save time since you do not have to monitor every investment individually. Rather, you only need to monitor the portfolio's performance and make any necessary adjustments. If needed, you can always consult your Mutual Fund Distributor.

Takeaway
Portfolio diversification is crucial for any investor looking to manage risk and maximize returns. Investing in various Mutual Fund Schemes that provide exposure to different asset classes and sectors in the economy can minimise the impact of market fluctuations and economic uncertainties, and increase the likelihood of achieving long-term financial goals. 

Disclaimer 

The information disseminated on AMFI website about various categories of mutual fund schemes is for informational purposes for creating awareness about mutual funds as a financial product category and not for sales promotion nor solicitation of business.

The content herein has been prepared by AMFI on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, AMFI cannot guarantee the accuracy of such information, assure its completeness, or warrant that such information will not be changed.

The content herein does not take into account individual investor’s objectives, risk appetite or financial needs or circumstances or the suitability of the mutual fund products described herein. Hence, investors are advised to consult their professional investment adviser/ consultant/ tax advisor for investment advice in this regard. 

A mutual fund scheme is NOT a DEPOSIT product and is not an obligation of, or guaranteed, or insured by the mutual fund or its AMC. Due to the nature of the underlying investments, the returns or the potential returns of a mutual fund product cannot be guaranteed. 

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.