Diversification Should Be Your Core Strategy

The last couple of months have been quite challenging for equity fund investors. A number of domestic and international factors have been keeping the stock market on tenterhooks. Considering that the stock market has the tendency to be volatile from time to time, investors are often faced with the dilemma of how to tackle these tough times. While there are strategies that can help them overcome these bouts of volatilities, many investors struggle to do this effectively as they follow a haphazard approach.

One of the proven strategies to tackle the vagaries of the stock market is to build a diversified portfolio and follow a disciplined approach to investing. Besides, knowing what to expect from each of the asset classes that are a part of your portfolio goes a long way in making you mentally prepared to face these rough times. In other words, diversification is the key to investment success as it not only reduces the risk in your portfolio but also allows it to perform in different market conditions. While a section of the investing public aims to achieve portfolio diversification by investing in different asset classes such as equities, debt and gold, it is equally important to have adequate diversification within an asset class.

Mutual funds have emerged as an ideal option for investors with varied risk profile and time horizons to achieve diversification. Apart from being a diversified investment vehicle in themselves, they offer a variety of funds within an asset class. For example, for equity portion of your portfolio, you have an option to choose from a variety of funds like large-cap funds, mid-cap and small-cap funds, multi-cap funds, index funds, sector and thematic funds, contra funds, and opportunity funds. If you choose well, both in terms of type and number of funds, you can not only restrict the impact of volatility on your portfolio but also get better returns over time.

Unfortunately, diversification is also an aspect of portfolio building where a number of investors err. The common belief is that more the number of funds one invests in, the more diversified the portfolio is. It is a myth that investors have been following for years. Even while investing through SIP, many investors invest in a number of funds. One often comes across portfolios where an amount as low as Rs 5,000 is invested through SIP in five funds. Remember, an over-diversified portfolio can dilute your returns over time as non-performing funds may pull down the overall returns. 

Moreover, having too many over lapping funds would invariably make your portfolio quite complicated. It is always difficult to keep track of a complicated portfolio. On the other hand, a few carefully selected funds in the portfolio could provide you higher level of diversification and that too without compromising your returns. Over-diversification can harm your portfolio in some other ways too. For example, a quality mid-cap fund is a must for a long-term portfolio as it can help in improving the overall portfolio returns. However, by having too many mid-cap funds in your portfolio for the sake of higher diversification would invariably make you compromise on the quality of the portfolio as stock picking and sound investment process are major differentiators for these funds.

Considering that the mid-cap segment suffers from poor liquidity and limited coverage, it is always prudent to opt for a quality mid-cap fund that not only has a quality portfolio but also an established performance track record. While there is nothing like an optimal number of funds that you need to own to have a sufficiently diverse portfolio, factors like size of your portfolio and your asset allocation can help you decide that number. Another important aspect that requires attention is the level of risk you are willing to take to meet your returns’ expectations. Risk tolerance should also be addressed from two perspectives: financial risk tolerance and emotional risk tolerance.

While investing in the right combination of funds and in the right number would ensure a good beginning to the investment process, monitoring their progress too remains the key. The right way to analyze the performance of your funds is to compare them with the peer group rather than the benchmark index alone. If required, don’t hesitate to get rid of non-performing schemes. By doing so and re-investing in funds that have a better quality portfolio and track record, you can enhance your portfolio returns. However, once you invest in a fund, give its fund manager sufficient time to perform.