Learning Mutual Fund Diversification

A Healthy Way To Diversify Your Mutual Funds Basket

There is a book called ‘The Intelligent Investor’ by Benjamin Graham which says, “The essence of investment management is the management of risks, not the management of returns.” Whereas, Ray Dalio, an American billionaire investor says, “Diversifying well is the most important thing you need to do in order to invest well.”

The point to highlight is that blanket investing is not enough, there are a few smart ways to religiously follow when you invest. Diversification is one of the most important aspects of that. Why? Because it helps you to manage risks and invest well.

Diversification is a fundamental aspect of investing where you spread your risk by investing in multiple assets or categories while exploring the potential of growth and opportunity. Don’t worry if it sounds technical, MINTIT will simplify it for you and teach you how to diversify well.

The first thought comes into our mind, is diversification important? Why not take a bet on one asset or category of asset and make exponential returns? Let’s learn from a story of two friends Amit and Milan. Here we go again!

Amit and Milan started their investment journey 5 years ago before the covid pandemic. Amit who wanted to make exponential returns invested all his money into the small cap categories mutual funds. On the other hand, Milan with the help of his fund manager invested across the large cap, small cap, mid cap and in the debt mutual funds. Then came a disaster, pandemic hit, market crashed, investments dipped. However, Milan’s investments managed to tolerate the shocks due to diversification, but Amit’s investment crashed more than 40%. Amit lost confidence in investing and redeemed his investments, whereas Milan’s portfolio recovered faster and grew steadily.

You see the role of diversification is to enable steady growth to your portfolio instead of zig zag shocks. Before we dive straight into the mutual funds’ diversification, let’s educate ourselves with the basics of mutual funds in brief.

Types of Mutual Funds

Mutual funds are classified into different types based on the assets class, size and themes.

Categories- Mutual funds are divided into three broad categories, Equity, Debt and Hybrid.

• Equity- As the name suggests equity mutual funds invest primarily in stocks and are considered as high risk, high-return funds. They are suitable for long-term goals.

• Debt- Debt mutual funds invest in debt instruments such as government bonds, corporate bonds etc. These funds offer low-risk and stable returns.

• Hybrid- These are a mix of debt and equity which aim to balance risk and return.

Market Cap- These funds are based on market capitalisation or size of the companies they invest in.

• Large cap- These funds invest in top 100 companies by market capitalisation. These are relatively stable and less volatile.

• Mid cap- These funds invest in top 101-250 companies by market capitalisation. Typically, mid cap companies have a market capitalisation between Rs 5,000 crore to Rs 20,000 crore.

• Small cap- These are the companies with the market capitalisation of less than Rs 5,000 crore. These are known as high risk and high reward funds. These funds tend to fall and rise a lot more compared to large and mid-cap funds.

Sectoral Funds- These funds pick a particular theme or sectors to invest which has a potential to perform better among other industries. For example, Infrastructure fund, Defence fund, Banking or Pharma etc. These funds, however, are cyclical and highly concentrated.  

Why to Diversify

Now let’s discuss the important parts of our blog, the need to diversify our mutual funds’ investments.

• Minimising Risk, Stabilising Returns

The main purpose to diversify our investments is to spread the risks across assets and categories. In times of volatility, our investments could go haywire, however the smart allocation into different assets saves our investment from a sharp fall which looks impossible to recover. You see our investments tend to grow over a period of time, but every asset has a different phase of growth which cannot be timed. So, to make sure that our total portfolio grows with stable returns over a long period of time, diversification is extremely important.

• Exposure to Multiple Growth Opportunity

With diversification, you can take advantage of investing in multiple assets or categories of funds. In times of volatility, large cap and debt funds can save you. During growth phases, small or midcap can add strong returns to your portfolio, whereas investing in a sectoral fund can give you the benefits of a sector-specific rally.

• Avoid Over Investing

Historically data suggests that mid-cap and small cap generate higher returns than large cap, however this greed is also a trap. Like Amit invested all his money in a single category and suffered harsh shocks of volatility. A financial crisis can occur anytime which can plunder the growth-driven assets, while the over dependence of safe assets can compromise with growth. Hence it is important to smartly diversify and avoid the trap of greed, cyclicity and low returns.

How To Diversify

The main ingredient of diversification is to learn ‘how to diversify.’ Diversification does not mean investing in the same category through buying multiple funds. For example, investing in the large cap funds of HDFC, ICICI, Motilal Oswal etc., this amateur behaviour is not diversification. Let’s learn the right ways to diversify.

• Investor Profile

An investor needs to clearly note his goals, risk ability and tenure. A proper and detailed analysis of an investor's profile is essential to get a good balance while diversification. For example, investors with aggressive risk ability prefer small and mid-cap mutual funds, while investors with short-term tenure consider debt mutual funds. However, this is the most crucial yet complicated step. But no! Worries, MINTIT is here to help you with this roadblock.

MINTIT, India’s only dedicated Mutual Fund Platform which caters to your personalised goals and accompanies you to achieve your financial milestones is eager to help you build your wealth. Depending on your profile it can precisely suggest tailored investing plans to achieve your financial goals.

• Don’t Mirror Mutual Funds

As we discussed above, do not invest in multiple mutual funds of the same category. You can add debt mutual funds for stability, a mix of large, mid and small cap for growth and moderate volatility. This way you can expose your investment portfolio with the right diversification.

• Sectoral Funds

It is suggested that the allocation towards sectoral and thematic funds should not go beyond 10% of your total portfolio. Consider these as satellite funds. These funds can be highly cyclical, for example, infrastructure funds did not gain for years. Now imagine being stuck in such a fund, a horrible mistake. However, they also perform well when the time comes. For example, Motilal Oswal Nifty Defence Index Fund with assets under management (AUM) of nearly Rs 3,000 crore delivered 16% returns in a single week after the demonstration of Indian defence ability by Operation Sindoor.

• Rebalance

Diversification also required regular rebalancing to keep a check if there’s an over allocation to a particular category or asset. Also, rebalancing is required to book profit and rotating capital from time to time. However, this is a complicated process and requires professional guidance. To cater this investors’ need, MINTIT with its specialisation in mutual funds can help you navigate this smart way of diversification. From risk profiling to rebalancing, look up to MINTIT.