How Diversification of a Mutual Fund Reduces Risk Associated With It
Off late with the rising focus on mutual funds, diversification has become one of the most used words among the investor’s community. In this blog, we, at Orowealth, seek to unfold what is diversification and how diversification in a fund helps reduce the risk associated with it.
What is Diversification?
It is the act or practice of owning a range of assets across a variety of industries, company sizes, and geographic areas. In simple words, diversification is the act of spreading the risk across multiple asset class including stocks, bonds, and cash.
The rationale behind diversification it that a portfolio constructed with different types of securities will yield higher returns while posing a lower risk than investing in individual securities.
How Diversification Reduces Risk
There is an old saying that says – “don’t put all of your eggs in one basket”. This is true to the financial sector. For example, investing in single securities makes an investor more vulnerable to risk. This is due to the fact that the entire value of an investment depends on the performance of just one kind of asset. In addition, by concentrating on a single asset class an investor could be missing out on lucrative investment opportunities elsewhere. Investing in a mutual fund provides diversification given the fact a fund typically invests in multiple securities or asset class.
Diversification involves creating a balanced investment portfolio with a range of a different kind of asset class and range of securities within an asset class. We believe a well-diversified portfolio is stronger than any one particular area of investment. In addition, with multiple securities, an investor is in a position to cope with market fluctuations against one single security. As a result, an investor is benefitted from more stable returns in the long run.
Perils of Diversification
Remember diversification isn’t a cast-iron guarantee that an investor won’t suffer losses. Capital market and investment instruments are bound to change thereby remaining unpredictable. With diversification, an investor can try to limit the damage or the downside risk while boosting the chances of reaching financial objectives. Remember, an investor can’t eliminate risk, but can just reduce it.
Benefits Mutual Funds Provide with Respect to Diversification
The following are the benefits that are provided by a mutual fund that also helps in building a diversified portfolio
- Investing in a variety of asset classes (e.g. bonds, stocks, etc.)
- Invest in more than one country or region
- Range of industries
- A range of companies across market-cap segmentation
- Avoid asset classes that exhibit a high level of correlation (i.e. those that respond to market forces in very similar ways). If investments go up or down, an investor will not be able to reap the benefits of diversification
How Diverse Should Your Portfolio Be?
There is no right or wrong degree of diversification; it depends on multiple factors such as age, horizon, and risk appetite among others. Following are some of the parameters that would help you assess your diversification level:
Including a diverse range of assets and risk levels in a portfolio can be ideal if an investor is committed for long-term, as there’ll be plenty of time for the high-risk investments to recover from periods of extreme volatility. If you are an investment tortoise, you can invest in a less diversified and less risky portfolio (typically debt funds).
Amount of capital
If you over-diversify your investments, you’ll spread your capital too thinly. This may result in high management cost thereby making investments less lucrative.
With high-risk appetite, you can invest in small-cap funds that provide higher returns over the long-term. If you’re a cautious investor, you might want to invest solely in low-risk assets such as debt funds. While these funds offer low returns they also tend to come with low risk.
Some Interesting Real-life Examples
We are sure you must have heard of David Swensen – the great American investor. David runs an endowment fund and has generated over 15%-annualized returns from 1985 until now. That is simply amazing as no fund manager has been able to achieve even half of what David has achieved. David typically doubled investors’ money after every 4-5 years. If you closely analyze his asset allocation, you will find that he is putting diversification to use the most.
In an interview Swensen suggested that an investor should ideally allocate his/her money in multiple asset class to ensure he/she is benefitted the most at any point in time:
|Real estate funds
|Developed-world international equities
|Treasury inflation-protected securities
If you see, the portfolio comprises of equities from the domestic market, emerging market, international developed market. In addition, it comprises bonds, inflation-adjusted debt instruments, and the likes. Thus, investing in single names under each of this category is undoubtedly a tedious task and in certain cases regulation doesn’t allow (for example – investing directly in securities of a developed economy). This is where mutual funds provide you with the benefit.
Should you wish to start your investment journey feel free to connect with us. Our expertise shall help you make sound investment decisions. We help our clients to navigate the complex world of investment and achieve their financial objectives with the help of data and provide investment ideas in the world of mutual funds.