Having a diversified portfolio is one of the essential principles of investing in mutual funds. Diversification is a technique that involves allocating investments among different financial instruments, sectors, and other categories. It ensures that you are not reliant upon a single investment for all your returns. Considering the volatility of the market, a diversified portfolio is exceptionally critical to reducing investment risk.
Building a strong portfolio requires insights and extensive analysis of the factors which may underperform or outperform in your chosen market. One needs to identify funds’ risks and then diversify strategies based on factor analysis. Such analytical research is effort-intensive and time-consuming. It’s a good idea that you visually compare factor exposure of your funds to its benchmark through a portfolio risk analyzer. The ready-to-use investment analysis data can be so useful for investment consultants, asset owners, asset managers, and wealth managers.
With investment in index funds, investors can capture returns from hundreds or even thousands of holdings, thus benefitting from broad diversification and lower relative market risks. Moreover, the lower expense ratio of index funds due to passive management and the cost savings from it directly pass along to the investors.
This article lists the benefits of diversification and how it can help you accomplish your financial goals.
Why should you diversify?
Let us assume you have a portfolio of only airline stocks. If in the future, airline pilots go on an indefinite strike and all the flights get cancelled, share prices of the airline stock will drop. This would also have a negative impact on the NAV of mutual funds in your portfolio.
If, however, you also bought some railway stocks to counterbalance airline stocks, only a part of your investment portfolio would get affected. In fact, the price of railway stocks could witness a hike as passengers turn to railways as an alternate form of commute.
But, since both these sectors relate to transportation, a smarter move would be to diversify even further to different industrieslike telecommunication, banking, pharmaceuticals, FMCG, etc. This way, you can avoid the risk that can affect both of these forms of travel.
Benefits of diversification
An experienced investor knows what is a mutual fund and that an ideal portfolio is comprised of different types of mutual funds including liquid funds, debt funds and balanced funds.
Here are the key advantages of diversification:
Reduces the impact of market fluctuations
We cannot predict how an asset class performs in the future or generate returns. But by spreading our investments across different asset classes such as cash, bonds, equities and more, we can minimise our portfolio risk.
A gain in another category can offset the loss in another category.
Minimises the time spent in monitoring the portfolio
If you invest only in equity funds, you may have to spend considerable time studying market trends. If you invest in low-risk mutual funds, you may have to lookfor better avenues to increase your returns. With diversification, you can spend lesser time on monitoring your portfolio as you are exposed to a mix of both.
Helps keep your capital safe
If you are a new investor who has just started investing, you may prefer stability in your portfolio. Diversification ensures that your savings or capital stays safe and you can achieve your investment goals too, while maintaining the risk at a minimum level.
Helps avail the benefits of compounding of interest
When you invest for the long-term, you can avail the benefits of compounding interest. Every investment made generates interest on the principal amount as well as the accumulated interest over the previous invested years. This can help you grow your wealth efficiently.
Helps you avoid losses due to bad timing
Many investors get swayed by market movements and end up taking emotional decisions instead of sticking to financial discipline. This especially happens when investors enter the market when it is climbing higher and panic when they start losing money on their investments as the price drops. Thus,an investment portfolio generates far lesser returns than the market average. When you diversify, you can achieve peace of mind as your financial discipline pays off richly in the end.
By diversifying your mutual fund investment portfolio,you can grow your wealth over time. Simultaneously, you can also reduce volatility and minimise your risk through a broader exposure to various sectors and stocks.