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How to Build a Diversified Portfolio with Mutual Fund Investments?

How to Build a Diversified Portfolio with Mutual Fund Investments?

Ever heard of the phrase “Do not put all your eggs in one basket”? Well, that’s what diversification means. The eggs refer to your funds, and baskets are the investment avenue.

In simple words, when you put your funds in multiple investment avenues, you mitigate risks. Mutual fund as an investment avenue is based on the concept of diversification; however, investing in one type of mutual fund may again discourage the main idea of risk mitigation.

In this blog, we shall share ways to build a diversified portfolio with your mutual fund investments.

How Can Diversification Help?

When you diversify your portfolio, you spread your investments to reduce the impact of poor-performing investments and the risks involved. Now, you must understand that every investment has an associated risk. Hence, risks can be classified into systematic (which affects all the asset class, for example, political instability, fall in GDP, etc.) and unsystematic risks (which is unique to an asset class or sector, for example, unrest in a particular industry, rising interest rates, etc.). So, the key here is that you cannot always avoid risks but certainly can manage them. That’s what diversification helps you with.

Consider this example. If you have made mutual fund investments in sectoral funds (technology, for example) and the sector is currently underperforming, you could suffer significant losses. On the contrary, if you diversify your portfolio by investing in different sectors, the risk is more spread out.

Ways to Diversify Your Portfolio with Mutual Fund Investments

Since we have understood how diversification helps, let us look at how you can diversify your portfolio.

  • Based on asset class: If your investment horizon is shorter, for instance, less than 5 years, it is better to limit your exposure to equity funds. You can consider investing in low-duration short-term debt funds to fulfil your short-term financial goals. Similarly, if your investment horizon is longer, equity funds are the best option to maximise returns. If you wish to park your funds without an aim to earn returns, liquid or money market funds are the best choices.
  • Based on sector or themes: To begin with, themes and sectors are different. In fact, themes consist of several sectors. For example, a thematic fund focusing on consumption may invest in various sectors like automobiles, FMCG, consumer durables, telecom, etc. This means that thematic funds are typically more diversified than sectoral funds.
  • Based on market capitalisation: Many equity mutual funds invest in companies depending on their market capitalisation. For example, a large-cap fund may invest predominantly in companies with a large market capitalisation, perhaps companies ranking 1 to 100 in the Indian stock market for market capitalisation. Typically, a large-cap fund is considered less risky compared to small-cap or mid-cap funds. However, more risk would mean better returns.
  • Based on duration: This is mainly concerned with debt funds. You can diversify your debt portfolio between liquid or longer-duration debt funds depending on your liquidity needs. Since duration is measured in years, if a fund invests in securities with a higher duration, it means you must have a long-term outlook for that fund.

Quick Tips for Diversification

  • Try to invest in funds that have no correlation with each other.
  • Do not over-diversify.
  • Ensure diversification keeps you on track for achieving your financial goals.
  • Investing in a diversified fund or a flexi cap fund can prove better compared to diversification across sectors and themes.
  • Use tools like SIP and lump sum calculators online to help you understand your investment value after a certain period.

Wrapping Up

Diversification is not about investing in most of the funds. Instead, it is about investing wisely to reduce your risk and achieve your financial goal. During market volatility, diversification is a strategy that can reduce your losses and generate impressive returns as the market recovers.

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