How to Build a Diversified Portfolio with Mutual Funds ?
Learn about creating a diversified mutual funds portfolio
CA Bhaskar Abhishek
12/6/20245 min read
Portfolio diversification is well understood and is one of the fundamental concepts of investing. It decrease risk, improve return and make sure that the money you invested is in the right channel to support your financial planning. Among the means of investing, mutual funds – the funds that possess diversification and professional management as inseparable characteristics – are the most suitable for this. In this guide, we will discuss all the steps to have a diversified portfolio with the help of mutual funds.
What does it mean to diversify a portfolio?
Diversification means the dispersion of investments in order to avoid risk as investors invest in various asset types, industries and locations. The idea is simple: don’t just rely on just one idea or focus on one thing alone. This way, another investment unit can probably make up for the loss, and maintain portfolio stability.
Why Mutual Fund Investors opt for Diversification?
Mutual funds include professionally managed portfolios of securities for which shareholders pool their monies in buying stocks, bonds or other money market instruments in the fund. Here’s why they’re ideal for diversification:
Built-in Diversification: The securities to be held by the mutual funds are numerous; hence they will not be a victim of high risks in the market.
Professional Management: Portfolio managers undertake research to make right choices for their portfolios.
Accessibility: Everyone has an opportunity to invest in a big way and diversify at that.
Variety of Options: Whether one wants to invest in equity, debt, or a combination of both or even own both the funds simultaneously, mutual funds have it all.
A simplified guideline on how to invest in mutual funds in order to create a diversified portfolio.
1. Define Your Investment Goals : To further illustrate, mutual funds still have to be chosen wisely prior to the decision To help, first define your financial objectives. Are you investing for:
Short-term needs (1–3 years)?
Goals that are set for the medium term (for a period between 36 to 60 months)?
Strategic goals (lasting over five years, e.g. retirement)?
Your goal will also determine which mutual funds you are to include in your portfolio.
2. Assess Your Risk Tolerance : Your risk tolerance defines the ability that you have to take certain risks with your portfolio, especially in volatile holdings. Here’s a general guideline:
Conservative Investors: Instead, it will primarily concentrate on debt funds or the balanced funds.
Moderate Investors: The diversified news of equity and debt funds must be chosen.
Aggressive Investors: Include targeting equity funds especially the mid-cap and the small-cap.
3. What Asset Allocation Should You Follow? : Portfolio diversification starts with how one allocates his/her assets. It means the act of spreading your funds in various forms of securities which are in the categories such as equity, debt and gold etc. A common allocation strategy is:
Young Investors (High Risk Tolerance): The investment proportion was as follows 70% Equity investment 20% debt investment, and 10% investment in gold.
Middle-aged Investors (Moderate Risk Tolerance): Equity 50%, Debt 40% Gold 10%.
Retirees (Low Risk Tolerance): This port was going to be funded by 20% Equity, 70% debt, and 10% Gold.
4. Expense diversification within the asset classes : That is where the need for a diversification within the asset classes comes into play or in other words, ‘within-the-classification diversification.’ Here’s how:
Equity Funds:
Large-cap for some stability in your investment portfolio.
Mid cap and small cap mutual funds for growth.
Managed funds for selective industry or topic.
Index funds for affordable diverse market sensibility.
Debt Funds:
Working capital that more or less get used up daily or over a very short time.
You simply cannot compromise when it comes to the major portion of your investments and you should therefore work towards accumulating long-term funds for stable returns.
Dynamic bond funds for alteration of rates of interests.
Hybrid Funds:
Systematic mutual funds with daily, weekly or monthly frequent switching between equity and debt.
High risk hybrid funds as means of attaining increased proportion of equity assets.
Other Funds:
Gold ETFs or gold mutual funds for hedging against inflation.
International funds for geographical diversification.
5. Assessing Performance of Mutual Funds : While selecting mutual funds, analyze their performance using these metrics:
Historical Returns: Evaluate the fund’s performance using data for the current and three past calendar years, five years, and ten years. Business stability is a good sign of the reliability of returns.
Risk Ratios: Ratios such values as Standard Deviation (volatility), the Sharpe Ratio (risk-adjusted returns).
Expense Ratio: Expenses are directly proportional to net returns; therefore reducing cost increases the latter.
Fund Manager Track Record: Having an experienced and also consistent fund manager helps when investing in mutual funds.
Portfolio Holdings: Make sure that the fund’s investments relate to your objectives.
6. Keep Balancing Your Portfolio With Fresh Investments Frequent : Markets fluctuate and so does your portfolio. This means your investments are always in the right proportions with regard to your objective. For example:
If equity markets are doing well their percentage within portfolio may rise. Even some equity sales, in order to pick up debt again to keep the balance. Each rebalancing should occur at least once a year or when the percentages of your portfolio differ from the target percentages.
7. Monitor Your Portfolio : Stay abreast with the financial market as well as monitor your portfolio’s performance. However, do not get upset to short-term trends in the market since these markets are volatile. If you need to shift gears what you are doing, regular monitoring allows you make the necessary changes.
Sample Diversified Portfolio
Here’s an example of a diversified mutual fund portfolio for a moderate-risk investor. This portfolio provides a balance between growth, stability, and inflation protection.
Equity
Large-cap Funds : 30%
Mid-cap Funds : 20%
Debt
Short-term Debt Funds : 25%
Dynamic Bond Funds : 15%
Gold
Gold ETFs : 10%
Common Mistakes to Avoid
Over-Diversification: Too many funds weaken the returns, as well as their management due to the major issue of dilution.
Chasing Past Performance: It is crucially important not to confuse past high-performance results with the future achievements of a fund.
Ignoring Expenses: High expense ratios are known to pull down returns.
Neglecting Rebalancing: A portfolio is diversified and one that contains stocks and/or bonds that are uneven and provide a higher risk.
Focusing Solely on Returns: Taking risk into consideration, consistency and, of course, the general goal.
Advantages of Having Portfolio Diversification
Reduced Risk: Slicing risk reduces the consequences which results from poor operation of one investment.
Steady Returns: They also include a combination of assets which is beneficial during the fluctuations as well as other risks accompanying market.
Goal Alignment: It makes sure that your portfolio changes to achieve new and different goals financially.
FAQs
1. How many mutual funds should an investor invest in a particular portfolio?
This investment should not include less than 5 or more than 7 mutual funds. Comprise of funds that belong to different classes and categories of assets.
2. Does SIP help to diversify?
Of course, Systematic Investment Plans (SIPs) enable the investment in a frequency basis and across different funds thereby removing the market timing factor completely.
3. Is it possible to attain diversification with one mutual fund?
There are other types of fund, balanced advantage or multi-asset funds, that achieve diversification in one investment. However a combination of funds is considered to offer better flexibility as will be discussed next.
Conclusion
Investing in mutual funds is one of the best ways to getting an excellent portfolio for long term gains. This way, you make more rational decisions with the risk and return levels against stocks and funds in order to maximize your outcomes. Look at the difference, it is not just about minimizing the risk, but also about the greatest potential for development.
Article by CA Bhaskar Abhishek
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