Investors are increasingly preferring mutual funds to begin their wealth creation journey as they offer ease of investment, liquidity, and transparency.

However, despite improved economic growth prospects, macroeconomic uncertainty, high interest rate, currency concerns, recessionary risk, etc., are among the key challenges that India struggles with at the moment. Now, these are the factors that may influence the market performance, causing volatility and may have an impact on one’s investment portfolio.

Investing your hard-earned money is a crucial step towards securing your financial future and achieving your financial goals. But, simply investing in mutual funds without following a effective investment strategy can be risky and limiting. This is where mutual fund portfolio diversification comes into play, and it’s not as complicated as it may sound!

‘Don’t put all your eggs in one basket’, that timeless adage tidily sums up the concepts of asset allocation and diversification in a mutual fund portfolio.

The significance of diversification in a mutual fund portfolio will be discussed in this article, along with tips on how to build a diverse and secure financial landscape for yourself.

[Read: How to Choose Mutual Funds For Your Investment Portfolio]

Asset allocation and diversification are the cornerstone of investing. Asset allocation is the equivalent of deciding how many of your eggs are you going to put into how many different baskets or asset classes. Diversification, on the other hand, is the spreading of your investments both among and within different asset classes.

The rationale behind this portfolio diversification goes a little deeper than just keeping the eggs in different baskets.

What Is Mutual Fund Portfolio Diversification?

Spreading your investing capital over a number of assets or securities within your investment portfolio is known as portfolio diversification. Diversification aims to lower risk and boost the possibility of generating more stable and reliable profits over time.

The fundamental tenet of portfolio diversification is the notion that various assets have different potential degrees of risk and reward. The positive performance of some assets during market volatility may assist in offsetting the bad performance of others if you have a mix of assets with low or negatively linked price movements.

[Read: Are You Investing in the Right Mutual Funds? Think again!]

It takes more than asset allocation to effectively manage risk. After all, investing all of your money in securities from a single asset class doesn’t offer much protection; instead, it will expose you to concentration risk. That’s where diversification comes in.

Simply said, consider your investing portfolio as a sumptuous buffet featuring a variety of meals from diverse cuisines. Similarly, portfolio diversification is spreading your money among several different investment opportunities rather than investing it all in one pot. By doing this, you raise your odds of long-term success and reduce your risks of losing everything at once.

Key Aspects of Mutual Fund Portfolio Diversification Include:

• Right Asset Allocation Mix – This refers to distributing your money among various asset classes, including gold, bonds, and the equity market. Each asset class has distinct risk and return characteristics, and by balancing them, one can create a portfolio with greater diversity.
• Geographical Diversification – Because economic conditions, rules, and market cycles can differ globally, investing in mutual fund schemes that track the markets of several developed countries and regions can help to further decrease risk.
• Sectoral/Thematic Diversification – Within the equity market, diversifying across various industries and sectors or themes like EVs, Artificial Intelligence, etc., can minimise exposure to specific business or economic risks that may disproportionately affect a single industry.

Do note that investment in sectoral/thematic funds is considered highly risky as it carries concentration risk due to its single-sector exposure. Savvy investors may consider allocating a small portion of their portfolio in sectors/themes with a good growth potential based on suitability and subject to a thorough analysis of the scheme performance and the sector.

Mutual fund portfolio diversification also offers several advantages to investors. To understand in detail, you may read this article – Benefits of Diversifying Your Investment Portfolio for Your Financial Goals And How to Do It?

While diversification can reduce risk, it does not eliminate it entirely, nor can it assure significant profits. A diversified portfolio’s success will be influenced by how well each asset performs separately and how they interact with one another. A thorough analysis, consideration of financial objectives, determination of risk tolerance, and routine rebalancing in response to shifting market conditions are all necessary for effective diversification.

A well-diversified portfolio containing a broad mix of asset classes like equity, debt, and gold will likely be less volatile over the long term than a portfolio concentrated in only equities or debt investments.

The specific combination of assets in a mutual fund investment portfolio is based on factors such as the investor’s risk tolerance, financial goals, time horizon, and market conditions. The essence of diversification is that the correlation between various asset classes, be it equity, debt, gold, etc., is negative.

Different asset classes perform differently under a certain set of market conditions. Equity performs better when the economy is strong because company earnings are expanding quickly. In this phase, bonds often do poorly since interest rates are rising and bond prices react inversely with interest rates.

[Read: The 4 Key Market Trends that Could Drive Mutual Fund Growth]

Investors view gold as a safe haven, and it often performs well when there is unrest in the world. At that time, investors remove their funds from equities and move it to the safety of the precious metal. The benefit for an investor, arising from the negative correlation of various assets, is that volatility in one market is cushioned by stability in another.

Core & Satellite Strategy for Mutual Fund Portfolio Diversification:

The Core & Satellite investment strategy is time-tested and adopted by many successful equity investors across the world. It facilitates optimum allocation across investment styles, with an aim to gradually build wealth in the long run.

‘Core’ refers to the portfolio’s more stable, long-term holdings. Investors may consider a less volatile asset class known as debt in order to offer stability to the portfolio. ‘Satellite’ refers to the strategic component that would support boosting the portfolio’s overall returns regardless of market conditions.

[Read: What Should Be Your Mutual Fund Investment Strategy at a Market High]

By wisely structuring and timely reviewing the Core and Satellite portions and the holdings therein, one can add stability to the mutual fund portfolio while strategically boosting the portfolio returns at the same time.

Diversification may look a little different for each investor. Factors such as time horizon and risk tolerance should be assessed on a case-by-case basis to determine how to best construct each portfolio to fit the individual needs of each investor.

That being said, a mutual fund portfolio for an investor can be classified into 3 key categories as follows:

1. Aggressive Mutual Fund Portfolio

An aggressive mutual fund portfolio is ideal for an investor with a higher risk tolerance level and a longer investment horizon. Extreme market volatility is what aggressive investors are prepared to accept. This way of thinking accepts volatility while expecting for much higher returns than inflation.

However, if the market has a major downturn, you will need a long period of time to recover from the value loss. If you’re in your 20s, 30s, or 40s, aggressive portfolios could work for you. This is due to the fact that you have a few decades to invest and make up for any market swing losses. This category includes:

Core: It should provide some stability but focus on more growth-oriented assets-for example, a higher allocation of diversified equity mutual funds, flexi-cap funds and value/contra funds. The ‘Core’ holding should comprise around 65-70% consist of equity-oriented funds.

Satellite: Here, investments should focus on opportunities with high-risk, high-reward potential. This includes sectoral/thematic mutual funds in emerging industries, mid and small-cap funds with high growth potential, international or aggressive hybrid funds.

[Read: How to Strategically Approach Equity Mutual Funds in Volatile Markets]

2. Moderate Mutual Fund Portfolio

If you have a medium level of risk tolerance and a time horizon longer than five years, a moderate mutual fund portfolio is the ideal option. In this scenario, one would be ready to put up with some market turbulence in exchange for returns that beat inflation.

This portfolio is best suited for risk-neutral investors who are willing to take a small amount of risk in exchange for higher returns. As a result, compared to conservative investors, their core and satellite allocations may be slightly riskier. This category includes:

Core: The core portfolio can consist of both equity and debt for stability and growth. This can include balanced funds, diversified index funds, or a mix of both equity and bond funds.

Satellite: Moderate risk-takers can invest in slightly high-risk mutual fund schemes. This includes sector-specific funds or growth-oriented large and mid-cap funds and multi-cap funds that are actively managed and have a solid track record.

3. Conservative Mutual Fund Portfolio

If you have a low risk tolerance, it is better to have a conservative mutual fund portfolio. Conservative investors prefer returns that are equal to or slightly higher than the inflation rate and are less likely to accept periods of significant market volatility.

Conservative or risk-averse investors place more value on stability and capital preservation than they do on rapid expansion. They must therefore concentrate on these elements while developing a core and satellite portfolio. This category includes:

Core: Conservative investors should focus on low-risk assets with stability and income generation potential, for example, debt funds, balance advantage funds or multi-asset funds.

Satellite: This part of the portfolio must be focused on conservative investments with high growth potential, such as less-volatile equity funds like large-cap mutual funds with exposure to blue-chip stocks, diversified equity index funds, or ETFs. The idea is to maximise returns while lowering the risk.

Remember that there isn’t a one-size-fits-all investment approach that works for everyone. Every investor has a unique risk profile, time horizon, and objectives. To withstand the waves of market fluctuations during different market phases, one must put their asset allocation depending on their suitability and construct a well-diversified all-weather portfolio.

This article first appeared on PersonalFN here