We often talk about building a diversified mutual fund portfolio to mitigate the risk of investing in only one type of fund. The logic behind portfolio diversification is to spread the investment across various assets that work differently from each other. If all your mutual funds move in the same direction, all of them may bring negative returns when the market goes down. That is when building a diversified portfolio comes in handy. SIP is the best strategy to diversify your portfolio, as it allows you to invest in various assets simultaneously without making a hefty payment upfront.
Here is a step-by-step guide to diversify your mutual fund portfolio.
1. Diversifying the Portfolio Across Asset Classes
Investing across asset classes is the first step to building a diversified portfolio. Invest in a combination of debt, equities, ETFs, hybrid assets, gold, foreign assets, property, index funds, etc. Doing that spreads out the overall risk meaningfully across various asset classes and reduces the overall portfolio risk.
2. Diversifying the Debt Fund Holdings Based on Quality
Even if a different quantum, debt funds are an indispensable part of asset allocation. Once you identify the asset class and outline the total debt exposure, diversify the investments within the asset class based on asset quality. The debt qualify depends on ratings. The higher the rating, the lower the yield. It is a trade-off for most investors in debt funds. Decide how much you must invest in state government securities and risk-free government securities. Coming to corporate debt, prefer assets with an AAA rating. While being wary of illiquid assets, avoid going below AA-rated debt investments.
3. Diversifying the Debt Fund Holdings Based on Duration
Diversifying the debt fund investments based on duration is an extension of maturity. The key is deciding whether you want to hold an investment for a short or a long time. The final decision largely depends on your liquidity requirements. Accordingly, aim to divide your portfolio between debt and liquid funds.
When choosing debt funds, choose a mix of assets with a duration below and above five years and those below one year. Take your decision based on your perspective of interest rates. Bonds with a long maturity often react negatively to increasing bond yields.
4. Diversifying the Equity Portfolio Based on Themes and Sectors
Sectors are industrial groupings like consumer goods, banking, information technology, pharmaceuticals, etc. For instance, steel and cement stocks benefit when construction activities are a majority. Therefore, as mutual fund investors, you must diversify your equity portfolio across sectors.
Themes cover various sectors, like the rate-sensitive theme. Rural demand theme benefits from tractors, FMCG products, fertilisers, hybrid seeds, agrochemicals, two-wheelers, etc. Automobiles, real estate, and banking sectors benefit when the interest rates decrease. If you diversify your portfolio by theme, it must include a sensible mix of themes.
5. Diversifying Across Funds or Companies
Diversifying the portfolio across companies is another good strategy based on various sectors and themes. Combine companies with high operating margins with those with high asset turnover ratios. Similarly, combine high dividend yield stocks with high growth stocks.
Checklist for the Diversification of Funds
Here is a quick checklist to diversify your mutual fund investment portfolio:
● Limit the number of assets. Investing in more than 8-10 funds will be useless as each fund will be diversified.
● Diversification means investing in assets with low correlation. If you hold a stock and add one more with a similar correlation, you will lose the purpose of diversification.
● Diversify across themes and sectors to get the maximum benefits. Rather than combining complex sector or thematic funds, buying diversified funds or flexi cap funds is better. Along with diversification, this strategy also provides the benefits of capitalisation.
● Sometimes, diversification may bring down your returns. A little bit of loss is acceptable. However, ensure that you are not compromising your financial goals by just focusing on diversification.
● Diversify your portfolio while aligning with your long-term financial plan. Use this goal as your guiding principle and ensure your asset mix does not differ significantly from your original plan.
Remember, mutual fund portfolio diversification is an ongoing process. You must monitor its performance regularly to make changes as and when needed. Investing in mutual funds through a SIP scheme saves you from making a large investment upfront, allowing you to diversify your portfolio across different assets even with limited money.
