The old idiom, “don’t put all your eggs in one basket” is the essence of diversification in financial planning. If you invest all your money in one company and if the company goes bankrupt, then you can lose all your money. Instead of investing in one company, if you split your investment in two companies, you will reduce the odds of losing your money by say 50%. By investing in four companies you will reduce odds of losing money by say 75%. Risks and returns are directly related. Different types of assets have different risk and return characteristics. Through diversification you will be able to balance risk and return to achieve desired results for your financial goals. As such, diversification is one of the most important aspects, if not the most important aspect of financial planning and portfolio management. We will see how you may use mutual funds to diversify your investment portfolio.
Though you may invest in different types of investment instruments like stocks, debentures, mutual funds, fixed deposits, gold etc in your portfolio, at a high level these can be classified into three asset classes, i.e. fixed income, equity and gold. Investors should note that real estate is also an asset class, but since most retail investors invest in real estate for self-occupation, it may not be considered an asset.
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Fixed income or debt is the lowest risk asset class. Within fixed income, risk free assets like bank Fixed Deposits and Government small savings schemes (Public Provident Fund, National Savings Certificates, Kisan Vikas Patra, Post Office Monthly Income Scheme etc. are the lowest risk asset. Risk free assets also give the lowest returns. Company FDs, debentures and debt mutual funds are subject to credit and interest rate risks of varying degrees, depending on the instrument or scheme.
Gold is a step higher than fixed income in the risk gradient. As an asset class, Gold has higher risk compared to fixed income, but lower risk compared to equity. Historically, over very long investment horizons (e.g. 10 years) Gold has given potential returns compared to fixed income in the long term and usually is seen as a hedge to inflation in the long term. In the last 10 years, Gold has given 9.2% return which is substantially higher than average bank FD rates over that period. However, gold can underperform fixed income for fairly long periods of time and investors need to have long investment horizon for gold.
Equity has the highest risk among all asset classes, but also gives the highest returns over sufficiently long investment tenure. At the same time, equity is much more volatile than either fixed income or Gold. In the last 2 - 3 years, the Nifty 100, which is the index of large market cap stocks, has underperformed both gold and fixed income. However over the last 10 years, Nifty 100 Total Returns Index has given 14.8% annualized returns, which was substantially higher than both Gold and Fixed Income returns.
Different asset classes also outperform each other in different economic cycles. Fixed income outperforms equity in bear markets, while equity outperforms fixed income in bull markets. For example, equity in India outperformed gold in the early 90s, but gold outperformed in the late 90s and early 2000s in the wake of the Asian currency crisis and the dotcom crash. Equity again outperformed gold from 2000 to 2008. By diversifying across different asset classes you will be able to smoothen your portfolio volatility in different economic or market cycles and at the same time get good returns in the long term.
There are two kinds of risk in equity investments, Systematic Risk or Market Risk and Unsystematic Risk . Market risk is caused by events which affect the whole economy of the country or world. Market risk is uncontrollable and investors should be prepared for market risk when investing in equity. The risk of share price of a company falling due to poor financial performance or any unfavorable development which can affect the industry sector is known as unsystematic risks. Unsystematic risk can be caused by company or sector specific factors. Unsystematic risk can be diversified by investing in a portfolio of stocks. If you invest in a sufficiently large number of stocks, then even if one or two stocks give poor results, your exposure to them is limited and your overall portfolio can still generate potential returns for you. Mutual funds are the one of the best instruments for diversifying unsystematic risks.
Two main risk factors in fixed income are interest rate risk and credit risk. You need to diversify your fixed income portfolio depending on your investment needs i.e. liquidity, investment tenure, risk appetite. Shorter the maturity or duration profile of a fixed income instrument less is the interest rate risk. However, short duration instruments usually give lower yields than longer duration. A mix of different duration profiles in your portfolio can help you meet a variety of liquidity, risk and returns objectives, according to your financial goals. As far as credit risk is concerned, lower rated instruments offer higher yield but the risk is also higher; you should make investments according to your risk appetite. Investors should also understand that while adverse interest rate risk is temporary, adverse credit risk is permanent. Investors should make informed decisions.
Mutual funds not only diversify company concentration risk i.e. risk of individual stocks underperforming, they also diversify sector risks by investing in multiple industry sectors. Different market cap segments have different risk profiles. Large cap stocks have lower risk than midcap stocks, while small cap stocks have the highest risk. On the other hand, midcap and small cap stocks usually outperform large cap stocks in the long term. A mix of different market cap segments in your portfolio according to your risk appetites, can not only help you achieve your long term financial objectives, but also aims to provide relative stability (limit downside) to your portfolio in the short to medium term. Certain types of equity mutual fund schemes like multi-cap funds, large and midcap funds etc also invest across different market cap segments which can help you diversify your portfolio risks.
Within fixed income asset class, mutual funds offer a variety of products catering to a wide spectrum of investment needs, tenures, risk appetites and liquidity requirements. Overnight, liquid and ultra-short duration funds are ideal for short term investments (12 months or less). Low duration funds and short duration funds are suitable for medium term tenures (1 – 3 years), while longer duration funds like medium to long duration, long duration, dynamic bond funds are suitable for long term tenures (3 year or longer). Debt mutual funds also offer different credit quality profile products like Gilt funds (no credit risk), Banking and PSU Debt funds (low credit risk), corporate bond funds (medium credit risk) and credit risk funds (medium to high credit risks).
Mutual funds may also help you diversify across different asset classes. By investing in hybrid funds you can get exposure to both equity and fixed income asset classes. There are different types of hybrid funds. Some hybrid funds have a higher exposure to equity, while some have higher exposure to fixed income and arbitrage strategies. You should select the appropriate fund based on your risk appetite.
Building a well-diversified portfolio requires a fairly large capital outlay because you will have to invest in a large number of securities. By investing in mutual funds, you can get the benefits of diversification with a much smaller investment e.g. Rs 5,000 only. Mutual funds pool the money of different people and invest them in different securities to create a diversified portfolio. Each investor in a mutual fund owns units of the fund, which represents a fraction of the holdings of the mutual fund.
We have long term, medium term and short term goals in life. Different asset types are suitable for different investment tenures and objectives. Equity and gold are suitable for long term goals. A mix of hybrid and fixed income may be suitable for medium term goals. For short term goals, you should invest only in fixed income. A diversified mix of asset types can help you meet each of your financial planning goals without compromising the other. Investors should discuss how mutual funds can help them diversify risks with their financial advisors before investing.