Jargons are most used when speaking about investments. And ‘diversification’ is one such jargon used by almost every financial expert. An old adage, “Don’t put all your eggs in one basket,” is what investment advisors suggest to investors’ to understand the importance of diversification. So, what exactly is meant by diversification? Simply put, diversification means spreading your investments across multiple asset classes so that your returns aren’t much affected by the volatility of the market. Investment is all about taking risk and generating returns from it. And the risk and returns have a high correlation - Higher the risk, higher the returns. No investment is immune to risk. And if the risk cannot be eliminated completely, at least effort must be taken to mitigate the same. In a nutshell, diversification of portfolio helps you minimise risk while attaining their set financial goals?
To understand diversification in a simple manner, let’s an example of a cricket team. In the team of eleven, we usually don’t have all batsmen or all bowlers. The team selection depends on the pitch conditions. Accordingly batsmen, all rounders and blowers are taken in the team. Similar kind of diversification is needed in our investment portfolio as well. Further, no single player is always able to keep his form. There are ups and downs through one's career. So, when one player is unable to score or take wickets, others manage to keep up the game.
Similarly, diversifying across investment categories gives one an edge when a category is underperforming. It might not completely eliminate the risk of underperformance, but can make your portfolio strong enough to face the volatile market.
Is diversification required in mutual funds?
While diversification is necessary for investment in general (equities, realty and mutual funds), the moot question is – is it particularly required in mutual funds? Many experts believe, while the diversification in different asset classes is necessary considering the risk associated with it – mutual funds is already a diversified asset class. Equity mutual funds themselves buy shares from very diverse industries. Like, mutual funds at any point are invested in between 50 to 100 companies. So, when one invests in an equity mutual fund, one indirectly owns shares of that many companies. Your portfolio is already very much diversified.
In fact, mutual funds are also marketed with such advantages of experts taking care of investment and investors enjoying the benefits of diversification even with the smallest amount invested. The answer here is, with multiple choices of different risk profiles like debt funds, sector funds, multi-cap funds and balance funds etc available in mutual funds – diversification is possible and is needed also. This leads us to the next section.
How Much diversification is considered good?
While diversification helps mitigate the risk, excess diversification leads to underperformance. It happens due to overlapping schemes, investing in similar instruments or stocks. Apart from this, there are certain disadvantages – it becomes difficult to track all investments. Further, too much diversification leads to similar holding and hardly results in any outperformance of any benchmark. If one invests in too many companies or mutual funds, and one of them does very well, one’s overall investment hardly witnesses gains. The mutual fund that did well would have caused a very small impact on your total investment (extensive diversification). So, one should limit oneself to owning a few mutual funds schemes.
Let’s take an example of large cap funds. The definition of large cap funds is top 100 companies in terms of market capitalisation. In this case, most of the mutual funds are investing in similar lots already well explored groups of companies showing growth. So, what sense does it make in investing in more large cap funds? The simpler way would be to select either one or maximum two large cap schemes and invest.
In the case of small cap and mid cap funds, the opportunities are on the higher side and most importantly the segment is usually less researched. No wonder even the growth opportunities and diversification opportunities are higher here. Chances of overlapping ownership of shares are lower here as the number of companies is more. As for small cap funds, the options available are higher. However, the kind of risk one needs to bear is on the higher side as well. When in bull markets, such companies witness a meteoric rise even if the decline is spectacular.
A clear learning emerges from this. While diversifying the portfolio – one must consider the factors like investment goal, risk tolerance and most importantly - the time horizon. So, it is advisable to go with the diversification based on the different mutual funds scheme. Let’s take it one by one.
Based on Market Capitalisations
Based on market cap schemes can be segregated on large, mid and small cap. As stated earlier, excess diversification in large cap is not possible due to overlapping shares. Either one or two large cap funds can be opted for if the risk taking capacity is lower. In the case of mid cap and small cap funds, up to two in each of the schemes is advisable. Given how high the risk is with these kinds of mutual funds, it is best to limit oneself to a limited number of mid cap and small cap mutual funds. Also, it advisable to avoid putting in a great percentage of investment amounts in small cap and mid cap mutual funds.
Debt Funds and Sector Funds
While the growth is taken care of by the above three funds, for consistent returns, debt funds need to be a part of your diversification strategy. Ideally, it should be one debt fund scheme, as most debt mutual funds give similar returns so it doesn’t make sense to own multiple debt mutual funds.
Another option is, sector based mutual funds. The number of sector mutual funds one invests in should be the number of industries one has great knowledge about. One can skip investing in these if they don’t have a very good idea of the sector. But if one has expert advice or understands the market cycles – sector funds are a good diversification option. However, it requires consistent follow up and tracking.
Conclusion: Based on risk profile, time horizon and risk tolerance it is advisable to hold 8 (plus/ minus 1) schemes for diversification purpose. Anything more than that would result in overlapping and the risk reward ratio won’t stand favorable.
Pro Tip: There is nothing wrong if one holds significantly more or in cases less number of mutual funds than what we have suggested here. Just provided that your decision is well informed and suits one’s risk profile and is inclusive of their financial goals.