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How much is too much when it comes to portfolio diversification?

By Finserv MARKETS - Aug 2,2019
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How much is too much when it comes to portfolio diversification


Mutual funds are an investment device whereby money in the form of investment is pooled from a number of investors who share a common financial goal. This pool is maintained by a fund manager – this involved investing the sum from the pool into various instruments like company stocks, shares and bonds, in accordance with the risk appetite of the investors. The risk profile of the investors is the governing parameter for the kind of portfolio the fund manager builds.

One of the main benefits of mutual funds often extolled is that they are able to diversify the portfolio and hence spread the risk. It’s a really simple concept now that you know what mutual funds are: since mutual funds pool capital from different investors, it reduces the overall risk of investment, and then the pool goes into different investment destinations.

These include:

1. Equity Funds

Equity mutual funds that invest at least 65% of their funds into equity shares. Classified as large cap, small cap, mid cap, sector-based stocks. Equity mutual funds are risky because their movement and growth are dependent on stock market performance. But the risk can potentially pay off well, with the dividend getting reinvested for goals of growth.

2. Debt Funds

Debt mutual funds invest in a range of fixed income instruments, like money market instruments, government securities, rated bonds, corporate bonds and debentures, commercial papers, treasury bills, and fixed income securities varying across their maturity periods.

These have assured returns and are opted by investors with low-risk profile and those who prefer ready liquidity.

3. Hybrid Funds

As the name suggests, these funds invest in a mix of debt and equity. In accordance with the investors’ risk profile, an aggressive hybrid fund will invest majorly in a bouquet of equities, and a conservative version will invest the majority in debt instruments.

The importance of portfolio diversification is not lost on any investor, no matter how layman or expert on the investment knowledge spectrum. No investments are immune to market-related risks and diversification is the ideal mode to mitigate risks and allow your portfolio to perform better.

The logic is that different industries and sectors don’t move up and down at the same time or at the same rate. They aren’t sensitive to economic forces in the exact same magnitude, so mixing up the portfolio makes your mutual funds investment less likely to experience major blows.

How much is enough?

Having realised and acknowledged the importance of portfolio diversification, the question of the hour is this: what is the optimum level of diversification for your mutual funds portfolio?

You might be tempted to think that risk gets proportionately reduced as you add each new stock in a portfolio, but that isn’t true. Nothing is good in unpalatable doses and mutual funds are no different. You can only reduce your risk up to a certain point. Beyond that, the benefit of diversification doesn’t exist.

Some mutual funds, especially the larger ones, face the issue of excess assets/cash to invest. They end up holding on to hundreds of stock and that makes it impossible to outperform index stocks. What would be the point of investing in a mutual fund then?

Equity mutual fund portfolios are considered concentrated if they encompass 25-30 securities, and diversified if that number increases to 40-60. Diversification might be measured in overlap with allocation in percentage terms. For instance, the allocation might be across 40 securities, but it still wouldn’t be well-diversified if 60-70% assets are held in the top 10 securities. These parameters have to be judged individually depending also on whether it is a small cap, mid cap or large cap fund.

Another diversification parameter is sectoral allocation. If a fund is optimally diversified, it will have around 50% of the assets concentrated in the top three sectors it invests in as a ballpark. This sector-wise categorisation is pivotal to understand because sometimes a portfolio may be excessively exposed to cyclical industries or interest-sensitive sectors, which may not bode well for the overall performance of the fund if things go downhill in a particular sector.

When you choose Finserv MARKETS to invest in a mutual fund, you can rest assured that your fund will operate at the optimum level – neither unreasonably risky nor too conservative. The process includes you and keeps you informed every step of the way too – you receive get financial planning tips and investment advice, detailed portfolio summaries and insights into the performance of your mutual funds and exclusive offers based on your risk profile and your investment goals. What are you waiting for, invest in mutual funds at Finserv MARKETS now!

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