We all have heard about mutual funds diversification at least once. But how do they work, and mutual funds portfolio were already diversified? If you have these questions, this is the right place to find out. This article is a complete guide to mutual funds investment and how to create a diversified mutual fund portfolio.
What are mutual funds?
A mutual fund is a financial vehicle that pools or combines money from different investors to invest in various instruments like stocks, securities, bonds, fixed income instruments, etc. Fund managers are experts in managing investments with an excellent understanding of the markets, manage these funds. They allocate funds from investors into different investment instruments after carefully analyzing the potential returns.
Profit earned from a mutual fund is divided among the investors in the proportion of their investment. The selection of stocks, investment instruments, and market forces play a significant role in the returns from a mutual fund.
Although investment in stocks and mutual funds is somewhat similar, both are different. Here are some features of mutual funds:
- Unlike equity shares, mutual funds do not give us voting rights or a fraction of the company’s ownership.
- Experienced fund managers manage mutual funds.
- The price of a mutual fund is calculated by dividing the total value of all securities within the fund by the total number of outstanding shares. The value of a mutual fund is expressed in terms of NAV or Net Asset Value per share.
- Investors can buy or redeem the units of mutual funds at the current fund NAV.
- Unlike equity stocks, the mutual fund price does not fluctuate during the market hours but is updated at the end of the day.
- The performance of a mutual fund portfolio largely depends on the performance of the individual securities in the fund.
- For instance, if an automobile stock is not performing well due to increased crude oil prices, another IT sector stock could perform well simultaneously. A mutual fund helps balance losses and gains, reducing the possibility of a loss.
- Mutual funds can invest in different instruments like equity, bonds, debt, and commodities. Additionally, choose a combination of other instrument types to reduce risk.
- The overall value is not affected by just one stock or security’s performance but depends on all the stocks’ performance in the fund.
- While investing in stocks might require us to have more money, there is no minimum investment limit for investing in mutual funds. Investment can start as low as INR 100.
- Mutual funds provide return and diversification at a meager price.
- A mutual fund generally consists of more than 100 securities, making it a highly diversified investment option.
What is diversification?
We all have heard the famous saying, “Don’t risk everything on the success of just one venture”. The simple logic is that if one venture fails to meet our expectations, the other well-performing venture can cover up for losses. Even though it does not assure profits, it reduces the possibility of losses.
Portfolio diversification divides investments over different asset classes to limit our exposure to a single asset. It helps reduce the overall volatility of our investment portfolio. As a beginner or an experienced investor, diversifying the investment portfolio can balance risks against our returns and provide us with more stable and consistent returns.
Diversifying a portfolio involves investing in stocks from different industries, countries, risk profiles, or other instruments such as bonds, real estate, and commodities. Spreading investments over various assets reduces the volatility of the investments and saves the investor from substantial capital losses.
Nevertheless, reducing the risk with the help of diversifying instruments also leads to lower returns compared to a non-diversified portfolio. The diversification degree depends on risk tolerance, investment objective and time horizon, and more. For instance, as someone with medium risk tolerance, we should consider including equity stocks and fixed-income instruments in our portfolio.
Why is diversification important to investors?
Diversification is one of the essential practices for investors, irrespective of the investment objective, risk tolerance, or market experience. Let us look at the reasons portfolio diversification is vital to investors and the benefits of diversified investment.
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Reduces the effect of market volatility
Diversification involves spreading the investment across different asset classes and industries. This further results in an overall reduction in the market volatility, as the risk balances with the return. For instance, if we have invested all our money in airline stocks. Any negative news related to the airline industry could result in huge losses. If we diversify our portfolio by including stocks from the IT sector or others, they might perform well and cover the loss caused by airline stocks.
Any diversification made across asset classes can also help reduce volatility. For example, having only equity stocks in our portfolio can be risky. However, suppose we create an optimum mix of equity stocks and fixed-income investments like bonds and debt. In that case, it can help reduce the effect of market volatility on our portfolio.
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Reduces the need to actively monitor investments
Diversified funds play a significant role in reducing the time spent on monitoring investments. Not all instruments will perform poorly at the same time. Investing in various assets means spending less time strategizing moves to reduce risk and increase returns. Diversification will minimize the need to maintain our investment portfolio.
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Advantages of diversifying instruments
Investors can also choose to invest in mutual funds. A diversified mutual fund portfolio will help the investor gain an advantage in investing in both debt and equity funds. Even if the equity funds do not perform well, the returns from the debt funds will balance the overall recovery and reduce losses.
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Aids investment objective
Every investor has an objective behind investing. While some might seek to increase their wealth, others might be planning to buy a car, house, invest in children’s education or even retire. Diversified funds help investors achieve their long-term investment objectives by providing specific investment stability and reducing risk.
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Safeguards capital
Investing in just one industry or asset class makes our investments highly vulnerable to market fluctuations. We can even end up losing a significant portion of our capital investments. Diversifying investments across different industries and asset classes helps reduce this risk. If one sector or asset class performs poorly, another industry or asset class will perform nicely and compensate for the losses. Therefore, diversification helps safeguard our capital.
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Allows investments shuffling
Diversification also allows the investors to shuffle their investments across stocks from different industries like automobile, IT, banking, etc. Investors can also mix their investments across asset classes like debt and equity to earn more stable returns. They can also invest in mutual funds to get a diversified portfolio of stocks from different industries and asset classes.
Mutual Fund Portfolio Diversification
Diversified mutual funds hold investments across different sectors and industries of the economy, multiple asset classes, and various geographical locations. The main objective of mutual funds diversification is that it helps mitigate the unsystematic or idiosyncratic risk. To some extent, we can control unsystematic risk.
Even though mutual funds portfolio are diversified, investors can further diversify them by investing in different mutual funds. They can individually invest in equity mutual funds, specialty funds, and debt funds or create a portfolio with mutual funds of various types.
Here are a few factors based on which we can diversify our portfolio:
- Diversification Within Asset Class: refers to investing in different types of securities within a particular asset class, for example, investing in stocks from various industries. Here the asset class remains the same, i.e., equity stocks.
- Diversification Across Asset Class: refers to investing in asset classes like equity stocks, debt funds, ETFs, fixed deposits, government bonds, etc.
- Diversification Across Geographical Locations: investors can also diversify across stocks and securities of different countries. Stock markets of various industries perform differently and can balance out the risks.
Before diversifying our portfolio, we must thoroughly analyze and determine a few things. Here are things to consider before diversifying.
- Investment Objective: determine the reason to invest the money and the desired amount at the investment horizon’s end. For example, our objective might be to increase wealth or buy a house.
- Time Horizon: Before diversifying, we must consider the time horizon to keep our money invested. For some, it could be six months to one year. For others, it could be more.
- Risk Tolerance: The next and most important thing to determine is the risk we are willing to take. While it is good to diversify, we must remember that the more we diversify, the less we gain. Therefore, we must balance the profits we seek and the risk we can tolerate before deciding the degree of diversification we want to undertake.
A step-by-step guide to diversification
While diversification is a great strategy, It should be done carefully and in a well-planned manner. Here is a 4-step guide to diversification.
Step 1: Ensure that our portfolio has funds of different types and must include mutual funds, cash, stocks, bonds, and exchange-traded funds. You can also invest in mutual funds, index funds, and ETFs.
Step 2: Ensure that the portfolio has both high-risk and low-risk funds. Include stocks and assets with varying risks in the portfolio. For example, we must include equity and debt components. For added security, consider investing in FDs.
Step 3: Diversify across sectors and industries. We must never put our money in stocks of one sector or other sectors related to each other. We aim to spread the investments across stocks of varying industries and ensure that they are unrelated.
Step 4: Consistently manage portfolios. Keep an eye on the portfolio and shuffle investments regularly. Stay updated with the market movements and changes to gain maximum benefit.
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FAQs
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What are the major types of mutual funds?
While there are various types of mutual funds available in the market, the three main types of mutual funds are as follows:
Equity Funds: are mutual funds that invest only in equity stocks. They diversify by stock purchasing across different industries. Such mutual funds are volatile and are primarily affected by market fluctuations.
Fixed-income Funds: are funds that invest only in fixed-income instruments like debt instruments, bonds, etc. Much safer than stocks and provide a consistent monthly income to investors.
Hybrid Funds: are funds that invest in both equity and debt funds. They maintain an optimum ratio to diversify the fund and reduce the overall risk.
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Are mutual funds a safe investment option?
Mutual funds are a safe investment option if we understand them well. Moreover, investors can start investing with a minimal amount, as there is no limit on minimum investment. Mutual funds are affected by market volatility and market supply and demand changes. Despite being affected by market fluctuations, diversifying our fund and including both fixed income and equity investments in our portfolio can minimize overall risk.
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Are returns on mutual funds tax-free?
The returns on mutual funds are not tax-free. Any gain from the sale of a mutual fund is treated as capital gains under the Income Tax Act 1961 and taxed accordingly. Any income in the form of a dividend is also taxable.
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How does diversification take place in mutual funds?
Mutual funds are already diversified, combining investments in different types of assets. This limits the exposure to any single asset and diversifies the risk. While we might think that investing in multiple mutual funds will help us diversify our risk, it is essential to note that two different mutual funds might have investments in similar stocks. Therefore, it is vital to ensure that each mutual fund invests in other stocks and that there is minimum overlapping.
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Is it a good practice to diversify investments?
Diversification is an excellent practice for those who want to minimize risk over the long term and ensure steady returns to fulfil business objectives. However, when looking for high returns, we should diversify less.
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Are mutual funds already diversified?
Yes, mutual funds are already diversified. Investors do not have to spend time strategizing and planning the diversification of investments and investing in mutual funds. Mutual funds pool money from investors and invest in various assets to reduce the overall risk.
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Is there something called too much diversification, and how to avoid it?
While it is advisable to diversify investments to reduce risk, over-diversification can result in erosion of our profits: the lower the risk, the less the returns. Therefore, the more we diversify, our risk and returns reduce. So, we must determine how much profits we expect to earn from our investments. This helps determine the optimum degree of diversification.
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What can be considered a well-diversified portfolio?
A well-diversified portfolio has stocks from different industries and different types of assets. A portfolio with an optimum mix of equity and debt instruments is considered the best, as it provides stability of return to the investors and reduces the portfolio’s overall risk.
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Can investors themselves manage mutual fund portfolios?
As investors, we can manage mutual funds our way. However, it is always better to leave the job to the fund managers. Fund managers are highly experienced and thoroughly know the stock market and other investment options. Let fund managers manage mutual funds to gain maximum returns is always better.
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