How to build a Diversified Portfolio – Guide to Diversification
What is diversification?
Diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset. In a nutshell diversification means not putting all your eggs in one basket.
Why is diversification important?
Do you know that many firms limit the number of executives that are flying in a plane together? By doing so, they are diversifying and hence minimizing the risk to the company in the unfortunate event of a plane crash. The concept of diversification is similar in investment. It reduces risk. Diversification casts a safety net that reduces the investment risks to a certain degree and enables you to limit your losses by optimising your returns.
How to build diversified portfolio?
Diversification can be done majorly in two ways:
1. Diversification across asset classes
It is also called as Asset Allocation and it is the first step to build any portfolio. There are different Asset Allocation strategies, some of them are:
a) Based on Risk Tolerance – Higher the risk tolerance, Higher the allocation in equities
b) Based on Investment Horizon – Longer the investment horizon, higher the allocation to equities
c) A combination of both of the above strategies
Hence, diversification can be achieved through proper asset allocation in Equities and Fixed Income.
2. Diversification within asset Class
a) First let us see Fixed Income :
Fixed Income includes debt instruments, i.e. EPF, PPF, Debt mutual funds etc.
- EPF is mostly for Retirement purposes, so if you are preparing a portfolio for Retirement Planning, do consider EPF under fixed income for that goal.
- PPF is for long term goals, you may consider PPF under fixed income for goals which have similar horizon to your PPF account maturity.
- For all other goals, use Debt mutual funds for your fixed income allocation. Go for debt mutual funds which invest in good Credit Quality instruments.
b) Now let us see Equities
- There are two ways to invest in Equities, first is through Direct Stocks from the share market and the other is through Equity Mutual Funds.
- Investing through Direct Stocks is risky since a thorough research is required to shortlist stocks to invest in and even after that your portfolio will be concentrated on 4- 5 stocks mostly.
- The second and more prudent way to diversify equity investments is through Equity Mutual funds. Mutual funds are inherently diversified as they invest in many different stocks which are shortlisted after through research.
- However, in Mutual funds also there are few points which an investor should keep in mind. We will discuss the same in next section.
How to build a diversified Equity Mutual Fund portfolio?
- There are many types of Mutual Funds available, Large-Cap, Mid-Cap, Small-Cap, Balanced, Sectoral funds etc.
- Sectoral funds should be avoided since they are riskier and the portfolio is heavyweight on a particular sector and a bad news might impact the performance. For example, let us say you have invested in a pharma sector fund and there is an unfavourable regulation change in the USA pharma sector. This will impact your funds too and the performance will decline.
- Invest in a combination of large cap, small/mid cap, and flexicap funds so that your investment is diversified along different sectors and is not concentrated on one or two particular sectors. Let us see an example:
In the below table, sector wise portfolio of 4 different funds, each belonging to a different equity fund category, is given. As you can see, each fund invests in different sectors, some have lower allocation to a sector and some have more, hence overall the portfolio is diversified into different sectors and the risk of poor performance of the portfolio due to one sector’s poor performance is minimized.
Example of a Diversified Portfolio
Based on the above method, a diversified portfolio of a moderate risk profile will have 60% in Equities and 40% in Debt. This can be further classified into:
- Large Cap – Birla Sun Life Frontline Equity – Direct – Growth – 30%
- Mid Cap – Franklin India Prima – Direct – Growth – 15%
- Small Cap – Reliance Small Cap – Direct – Growth – 15%
- Intermediate Bond fund – Birla Sun Life Treasury Optimizer – Direct – Growth – 20%
- Short Term Government Bond – SBI Magnum Gilt Short Term – Direct – Growth – 20%
Points to remember
- The objective of diversification is not to guarantee returns or eliminate risk. It does not ensure high gains or prevent loss of investments. It reduces risk and lowers the volatility of your portfolio.
- Do not over-diversify. There is an old proverb, “Too much of a good thing is good for nothing”. The same applies to diversification too. Keep the portfolio simple and do not go on investing in too many funds. Five or six funds should be sufficient to create a diversified portfolio.
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New to Mutual Funds? Learn more about basics of mutual funds here.