Diversification means to have more variations of something. In the context of mutual fund investments, diversification means investing in more than one type of mutual fund and have variations in the asset class.
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What is diversification in mutual funds
Mutual fund investment diversification means to diversify one’s investment into various types of mutual funds after doing a careful study of the personal investor and risk profile.
There are multiple options in mutual funds for investors. The broad categories are equity mutual funds, debt mutual funds and gold funds. These broad categories have their risk levels: equity is riskier than debt. Gold, at some level, carries the least risk of the lot.
Within the broad categories, there are subcategories again. For example, in equity mutual funds, large-cap funds are less risky than small and mid-cap funds. In debt funds, corporate bonds might be riskier than those who have more exposure to government securities.
Meaning of diversification: Hence, diversification means that an investor keeps his or her investments across different asset classes to balance out the risk and losses and have a net-net favourable financial position.
How does diversification work in mutual funds?
Like mentioned before, diversification requires investors to be privy to their risk appetite and life goals. Since we already know why this is important, let’s delve straight into how it is supposed to be done.
Define risk appetite
The first step to understanding what is diversification is to define your risk appetite. Risk appetite is an investor’s appetite for how much he or she can afford to lose money. If an investor is psychologically well placed not to get very disturbed, seeing high scale variations in their investment during the short term, he or she may be a little high on the risk scale.
Not just psychologically, but one should also be able to afford short term fluctuations financially and have enough liquid money parked somewhere else to help you sail through such situations. This does not mean all investments have a high chance of running into losses. Losses are notional and on paper till investments are redeemed.
Match Risk Appetite with Goals and Investments
Different types of diversification come with different types of investors. A risk-loving investor will diversify differently than a risk-averse investor. Let’s take a look at different diversification examples.
A risk-loving investor can ideally have more exposure towards equity-oriented investments and lesser towards debt-oriented investments. Even though the risk appetite is high, it does not mean that all the money can be in equity. This is where diversification comes into the picture.
Diversifications help to even out the losses and balance the risk across asset classes. If any day any of the investments have to be redeemed, and the markets are not doing well, the debt investments may be helpful to redeem and to not run into losses. To begin with, such an investor can invest 60% of the investible corpus in equities and the rest in debt and gold.
For the sake of an example: if ‘A’ has Rs 100 to invest, A can keep Rs 60 for equity funds, Rs 30 for debt funds and the rest in gold.
Within equity, we have multiple categories with varying risk levels, as mentioned above. Naturally, there will also be different types of diversification within equity as well.
Aggressive equity investor: An aggressive equity investor can invest more in small and mid-cap funds, lesser exposure to large-cap funds out of the total equity exposure. So out of the Rs 60, A can keep around Rs 15-20 for large-cap funds and the larger portion for small- and mid-cap funds which are the riskier categories.
Conservative equity investor: A can do the opposite if he/she falls under the conservative equity category. This is another diversification example. Conservative equity investors are those who have the appetite for equity but still want to play it safe. Such investors can have more exposure towards large-cap funds and lesser towards the peer categories. So out of the Rs 60, A can keep around Rs 15-20 for small and mid-cap funds and the larger portion for large-cap funds which is less risky.
This is a small bit of a larger illustration of diversification in mutual funds.
Diversification in debt-oriented funds:
Dent funds which have a higher exposure towards government bonds are less risky than corporate bonds. One can accordingly diversify their investments in the debt fund category after assessing your risk level.
Things to keep in mind before diversifying investments
Risk: Assess risk appetite to know which asset class suits more. This has been exemplified in a detailed manner above.
Goals: If A has short term goals but has risk appetite and outs more money in equity, A might land into trouble because equity gives high returns only in the longer term. It is not ideal for short term investments. Therefore just knowing risk appetite is not enough; one needs to know when is the money required. In debt funds, there are liquid, ultra-short and short term debt funds that are meant for short term investments. One can make an informed decision if the goals and time horizon are adequately assessed.
To Sum Up: Thin line between diversification and over-diversification
Over diversification takes place when an investor’s portfolio is overburdened with stocks or mutual funds where the marginal benefit of reduced risk is lower than the marginal loss of expected return.
Optimum diversification means that your portfolio should be large enough to eliminate risk but small enough to concentrate on the benefits.
Let’s look at an example.
If A owned 500 stocks of different companies, he/she has reduced the risk, but at this stage, the portfolio may not have many high-performing stocks.
There may come a day where A will end up in a no-profit-no-loss situation.
In the context of mutual funds, a fund that invests in more than 100 companies may not be the epitome of optimum diversification. At times this may make it difficult for the fund manager to get the ‘alpha’, meaning, to outperform the index. A new fund is suitable for your portfolio, but too many funds reduce the extent of gains an investor can get from having few but good funds in the portfolio. To conclude, large scale diversification may not make an investor loose much, but an investor may not gain a lot either.