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How to choose funds to diversify your portfolio

How to choose funds to diversify your portfolio
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Diversification is the concept of employing multiple fund investments for reducing the overall risk in one’s investment portfolio. It can be viewed from various dimensions:

  • Asset-class diversification, in which the investor selects investments across different assets like gold, debt and equity in his/her portfolio.
  • Market diversification, in which he/she chooses amongst small cap, mid cap and large cap funds, apart from international and sector funds.
  • Then there is management style diversification wherein the investor allocates funds across different fund houses in order to benefit from different management styles.

However, all these dimensions don’t weigh equally when it comes to their significance. It’s the asset class diversification that is given the most importance, as the variant co-relation between different asset classes holds plenty of significance, necessary for bringing about the desired diversification in one’s portfolio. Market diversification holds importance as it delivers an effective spread of risk, by providing ample variance between the risk-to-return profiles of different mutual funds, targeted at different market segments. Management style diversification holds importance in certain mutual fund types where the stock-picking ability of the management plays a critical role in delivering optimum returns, for instance in case of mid cap and small cap funds.

There is no specific thumb rule for inclusion of a certain number of funds in order to accomplish the right level of diversification in one’s portfolio.

A person having a small monthly investment amount can achieve both asset and market diversification fairly reasonably by opting for a single equity-based balanced fund through a systematic investment plan. On the other hand, another person can invest into 4-5 different funds – a diversified fund, a large cap fund, a debt fund and a couple of small or mid cap funds from different mutual fund houses to accomplish a more comprehensive diversification.

In general, you can achieve a pretty well-diversified portfolio by investing into 5 to 7 funds, including a sector and an international fund.

However, it’s important to determine your asset allocation strategy before selecting the mutual fund schemes for diversification. The way to go about investing into mutual funds is by investing separately for different life stage goals, and creating separate goal-based portfolios. For instance, you can have a portfolio for your child’s education, a separate one for emergency situations, and another one for retirement and so on. Such organization will allow you to devise separate asset allocation and diversification strategies.

Keep in mind that investing into too many funds can be disadvantages and beat the core purpose of mutual fund investments, which is convenience. The need for keeping track of several different fund investments will completely negate this purpose. In general, ownership of a large number of funds in a portfolio is driven more by a salesman’s push and less by the intrinsic need of the investor. So, invest into 5 to 7 funds of different types which are managed by well experienced and different fund managers, and you’ll be fine.

Mutual fund investments are subject to market risks, read all scheme related documents carefully.

 

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