A Diversified Portfolio Guarantees Investment Success

One of the challenges for investors in today’s complex financial environment is to manage risk. The best way to manage risk is to build a diversified portfolio. In fact, a diversified portfolio also helps you to tackle different market conditions. However, to benefit from true potential of diversification, one must diversify portfolio both in terms of allocation to different asset classes as well as within an asset class. While a goal based investment approach goes a long way in ascertaining the right mix of asset classes in the portfolio, an investment option like mutual fund allows you to diversify efficiently within an asset class.

Apart from being a diversified investment vehicle, mutual funds offer a variety of funds within an asset class. For example, for equity portion of your portfolio, you can choose from a variety of funds like those investing in different segments of the market i.e. large cap, mid-cap & small cap, multi-cap funds, index funds, sector and thematic funds as well as specialty funds.  

Unfortunately, diversification is also an aspect of portfolio building where investors usually follow a haphazard approach. It is quite common to see investors having a large number of funds in their portfolio as they believe it to be the right way to achieve diversification. If you are one of those investors who have built an over- diversified portfolio, you must know that too many over-lapping funds would invariably make your portfolio quite complicated. Besides, the failure to weed out non-performing funds can impact your overall portfolio returns negatively. In reality, a few carefully selected funds in your portfolio could provide you much higher level of diversification and that too without compromising your returns.

In fact, over-diversification can harm your portfolio in more than one ways. For example, investing in too many mid-cap funds for the sake of higher diversification could make you compromise on the quality of the portfolio as stock picking and sound investment process are major differentiators for these funds. Considering that mid-cap segment suffers from poor liquidity and limited coverage, it is always prudent to opt for a fund or two that not only have quality portfolios but also boast of 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 the portfolio and your asset allocation to different asset classes can help you decide that number. You must also consider 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.

Another important aspect of diversification is time diversification i.e. remaining invested over different market cycles. It is particularly important when you invest in a volatile asset class like equity. Considering that volatility is a natural phenomenon in the stock market, a systematic investment approach coupled with long-term investing can turn this volatility to your advantage through “rupee cost averaging”. Moreover, longer time horizons allow you to take on greater risks, with a greater potential to earn better returns, as some of these risks can be reduced by investing across different market environments. Similarly, if your time horizon is short, you would have greater liquidity need. Hence the focus should be on investment options that provide liquidity with reasonable degree of safety of capital.

As is evident, the length of time you remain invested is important. While time horizon plays an important role in deciding your asset allocation, you must maintain it closer to the original allocation at all times. Rebalancing the portfolio is another strategy that helps you maintain the right level of diversification in the portfolio.