Diversification is one of the most critical principles of investing. The objective of diversification is to avoid concentration of any single investment or asset class in your portfolio, thereby reducing overall risk and optimally positioning your portfolio for long-term wealth creation.
Investing in diverse asset classes like Equity, Debt and Gold, which from a performance perspective, are not correlated to each other, can empower a smart investor to diversify his/her investments. The proportion of investments in respective asset classes should be a function of risk appetite and financial goals of the investor.
For example, an investor with a 5-year investment horizon and a moderate risk profile can consider allocating 30% to equity investments, 60% to fixed income assets and 10% to gold. The equity allocation shall enable long-term wealth creation, fixed income allocation shall enable stable and consistent returns, and gold allocation shall act as an inflation and volatility hedge.
While diversification across asset classes is critical, it is also important to diversify within an asset class. As an example, if an investor invests directly in stocks, it is prudent for them to diversify across multiple stocks of different sectors and sizes so as to avoid concentration risk to their entire investment corpus in case certain stocks fail to deliver.
Taking the above example forward, out of the 30% equity allocation, investors may look at parking 24% in largecaps which are established businesses and thus more stable, and 4% and 2% can be allocated to mid and small-cap companies to position the portfolio for growth while at the same time optimising market risks.
Mutual funds have become increasingly popular and have established themselves as an investment product of choice for High Net Worth as well as retail investors. Mutual funds offer the professional expertise of the fund manager, are diversified instruments, transparent in terms of management and offer investors simple and seamless access to capital markets.
From a diversification standpoint, mutual funds invest in 40-70 stocks on average, which is already well diversified. It becomes crucial that investors select an appropriate number of Mutual Fund schemes. For example, if an investor invests in 8-10 equity mutual funds, there could be a reasonably high overlap in terms of underlying investments resulting in diversification which neither helps in reducing portfolio risk nor helps in enhancing returns.
Another big challenge is that it becomes increasingly difficult for investors to track and review each fund in the portfolio when there are a large number of funds. Conducting an annual review of your portfolio is crucial to ensure that you have the right set of funds in your portfolio to achieve your long-term financial objectives.
To de-clutter and simplify your portfolio while ensuring adequate diversification, you may consider the following measures. The first step is to accord meaningful weightage to the best-performing funds. Schemes should be evaluated on an individual level as well as should be compared with their peers periodically.
Schemes which are lagging in performance on a sustained basis should be evaluated and weeded out. Secondly, investors should try and avoid investing in too many schemes from the same Mutual Fund category.
Lastly, one can research and avoid investing in funds that have a major holding overlap with each other. Investors should conduct a periodic assessment of one’s own financial goals and risk appetite to determine the asset allocation strategy and rebalance/exit from mutual fund schemes, which are not in-line with the same. To make this process more disciplined and professional, investors may take the help of a financial advisor.
While there is no precise answer for the number of funds one should hold in a portfolio, 8 funds (+/-2) across asset classes may be considered optimal depending on the financial objectives and goals of the investor. Further, higher allocation of portfolio to the right fund is of crucial importance. There is nothing wrong in deviating from the said number; however, one’s decision should be well-informed after taking into consideration their holistic investment goals and objectives.
(The author, Virendra Somwanshi is the Head of Wealth Management, Capital Markets & NRI at Bank of Baroda. Views are personal)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
