What is Diversification in Mutual Funds? How does it work? Diversification in Mutual Funds Done Right!

All of us have heard the famous saying “Don’t put all the eggs in one basket”. All the financial experts keep using this line every time they mention diversification. What is diversification? Simply put, it means spreading your investments across multiple asset classes so that your returns aren’t much affected by sudden volatility in the market. Most investors, including me, strongly believe that diversification can be achieved by investing in different investment products. But, investing in mutual funds can also diversify your portfolio in an ideal manner.

Why Diversify Investments?

The need of the hour is to diversify. Investments aren’t immune to market risk. A dip in the value can be seen in every market cycle. As much as there are new developments by the companies there are as many new scams unfolding in the market. Volatility in the market has led to higher highs and also lower lows. If one sector is performing well doesn’t mean the other does too.

Diversifying across categories gives you an edge when a category is underperforming. Diversification can help you reduce the risk of investing. It might not completely eliminate it, but can make your portfolio strong enough to face the volatile market.

Diversification with Mutual Funds

Ron Chernow rightly said mutual funds have historically offered safety and diversification. And they spare you the responsibility of picking individual stocks. Without in-depth knowledge of the asset class, you can spread your risk with diversification.

Equity, debt and balanced mutual funds can help you diversify your investments. Equity mutual funds invest in equity markets. There are multiple options available to you like the large, mid, small and multi-cap. Debt funds invest in various corporate bonds, government bonds, and money market instruments. They give a better return than traditional FDs. Balanced mutual funds are hybrid instruments of debt and equity. They strike a balance between the two asset classes. It’s like getting the best of both worlds. Avoid sector-specific and thematic funds if you have little to no knowledge about the sector.

Ideal Diversification or Over Diversification

Investment in how many funds can lead to ideal diversification? An ideal number of funds depends on the amount of investment, horizon, goals and risk appetite. A maximum of 5 mutual funds is considered ideal when it comes to equity mutual funds. These funds have to be spread across various market segments and fund management styles.

Investing in too many funds can make portfolio management difficult. Over diversifying can lead to lower returns. In over-diversification, you end up investing in similar sectors. It is always good to choose one to two schemes per category.

DIY (do it yourself) mutual fund investors are more prone to the risk of over-diversifying their portfolios. They consult multiple experts who end up giving similar recommendations. Leading to a portfolio which is invested in a few similar segments.

Is there any solution to this problem? Yes, consult a financial advisor who will help you with the ideal diversification. Online portals like FinPlay have developed an algorithm to help you choose funds. They pick up funds which have performed consistently over a period of time and not the chartbusters or dark horses.

Apart from taking help from an expert, there are a few steps that you need to follow too. Avoid getting excited by the market’s ups and downs. Give enough time for your investments to make the best out of the market conditions. Stop switching between funds in a short time span. This will only lead to an unmanageable portfolio. Choose a scheme that matches your investment requirements and best fits your risk appetite.

Keep in mind what John Neff said about diversification. “Obsession with broad diversification is the sure road to mediocrity.” Do not be mediocre when it comes to investments.