Investment in mutual funds can be a good method to meet various financial objectives of an individual such as purchasing a house, planning for the future or making an emergency fund among others. Investing in mutual funds just because they provide a high rate of return may not necessarily result in a suitable investment strategy. Mutual fund investment should be in such a manner that it allows diversification of the portfolio among various asset classes, fund categories and market segments. Diversification should suit the financial goals of an investor and his/her level of risk tolerance.

Having knowledge of creating a diversified mutual fund portfolio can enable you to make better decisions.

What is a Diversified Mutual Fund Portfolio?

A diversified mutual fund portfolio refers to a portfolio that involves an investor investing his or her money in diverse kinds of mutual funds. Rather than having the total amount invested in a single kind of mutual funds, the investor can allocate his investments in diverse kinds of mutual funds according to his need. The kinds of mutual funds include:

• Equity mutual funds: These mutual funds primarily invest in stocks and are viewed as best for wealth creation over the long term depending on the risk capacity of the investor.
• Debt mutual funds: These funds involve investments in fixed-income instruments.
• Hybrid mutual funds: These involve investments in both equity and debt instruments.
• Index funds: These funds follow a particular market index, thus involving investments in the group of instruments contained in that market index.

The diversification process aims at not eliminating risks from investments but making sure that one does not rely heavily on any single type of mutual funds.

Why Diversification is Important for Your Mutual Fund Portfolio?

Having many mutual funds will not necessarily lead to diversification. A diversified portfolio may consist of many mutual funds that invest in stocks or sectors that are very similar. A portfolio of diversified funds offers many advantages.

1. Helps in Minimizing Investment Risk
Various types of investments can react differently to market fluctuations. Therefore, having a diversified portfolio minimizes the risks associated with unfavorable performance of some particular segment of the portfolio.

2. Matches Investments to Financial Objectives
Various objectives will be met by various approaches. Long-term financial goals may involve greater investment in equity funds, while short-term needs will involve more conservative investments.

3. Minimizes Relying on One Market Segmen
Having various market capitalizations, sectors and asset classes in the portfolio may minimize the risk of over-reliance on one particular market segment.

4. Helps Plan Long-Term Investments
Having a diversified portfolio may help structure your investments. Rebalancing the portfolio allows investors to keep the same proportion of various asset classes as market conditions change.

How to Create a Diversified Mutual Fund Portfolio According to Your Financial Objectives

Portfolio creation must start with knowing why you are investing. Here is how it can be done.

1. Determine Your Financial Objectives
First, you should list your financial objectives and the amount of money that you will need for their realization. These objectives can include:

• Short-term objectives: Creating an emergency fund, vacation planning or buying something expensive.
• Intermediate-term objectives: Buying a house, further education or any other expenses which you expect in the near future.
• Long-term objectives: Planning your retirement or your children’s education.

Time frame allocation will help you realize how risky the investments can be.

2. Know Your Risk Tolerance
Risk tolerance is your capacity to deal with changes in the value of your investments. For instance, an investor who feels okay with market instability and has an extensive investment period may be willing to take on some risk by having a greater percentage of investments in equity mutual funds. An individual who needs the investment funds soon may choose a more cautious route. Think about the following aspects:

• The stability of your income
• Any savings and investments
• Financial obligations
• Investment experience
• Capacity to bear any losses

It is your risk tolerance that will dictate your asset allocation and not the market conditions or performance of others’ investments.

3. Select Mutual Fund Classes Appropriately
Once you have figured out your investment objectives and risk tolerance, choose mutual fund classes suitable for your investments.

Investor must be aware of the risks involved, investment philosophy and portfolio construction of each fund before making any investments. The fact that a fund belongs to a certain category does not mean that it is appropriate for the investor’s needs.

 4. Determine Your Asset Allocation
The asset allocation is the way investors spread their investments between equities, debt securities and other types of assets. So, an investor whose financial target has a long horizon and relatively high risk capacity might want a higher equity proportion in his/her portfolio. An investor with a short horizon may prefer a larger share of low-volatility investments.

Consider this illustrative allocation:

It is just an example, not an ideal proportion for all investors. The right proportion will depend on the financial objective, time frame, risk tolerance level and the entire financial status of the individual.

5. Avoid Having Mutual Funds Investments That Overlap
Just because you have invested in various mutual funds does not mean that your portfolio is diversified. In case you invest in three large-cap mutual funds that include the same firms in their portfolios, there could be much overlap within your portfolio. You might end up owning similar firms in more than one fund without knowing. Before you make any fund choices, you need to analyze the:

• Largest stock holdings
• Sector allocation
• Investment strategy
• Portfolio composition
• Risk profile

A small number of selected funds with varied investment techniques will help in creating a more diverse portfolio compared to many funds that share similar characteristics.

6. Invest Consistently through SIPs
Investors can invest a certain amount of money in a mutual fund using a Systematic Investment Plan. SIPs help to create investment discipline and also helps to buy at various market levels. This is beneficial to those investors who would like to invest slowly instead of investing large amounts. But SIP does not guarantee any returns and also does not secure an investor from any market loss.

7. Check and Reallocate Your Portfolio
Over time, your portfolio will start moving away from the initial allocation since different assets earn returns at different rates. For instance, if you have invested in equity funds, these may grow larger than what you had initially planned to allocate. Rebalancing is the process of reallocating your investments so that your portfolio will be closer to the targeted asset allocation. Check your portfolio regularly or if there are any major changes in your financial circumstances.

Common mistakes When Diversifying Your Mutual Funds Portfolio

There are certain errors which people having investments in mutual funds might commit, leading to the unbalance in the portfolio of investments.

• Selecting mutual funds just because of their past performance: Past performances do not always guarantee future performances.
• Buying too many mutual funds: People having mutual funds in large numbers can create too much trouble.
• Failing to have a vision of your financial objectives: A mutual fund suited for a long term objective will never suit a short term objective.
• Not taking care of risk factors: There are various risks associated with equity, debt and hybrid mutual funds.
• Not having a check over the portfolio: Market conditions along with individual situations change.
• Relying on market trends: It is better to have your own investment decisions rather than being excited with the trends of the market.

Create a Portfolio That Moves You Closer to Your Goals

Your diversification of mutual fund investments should be centered on your financial goals, time horizon and risk tolerance, not on how many funds you hold or their performance in the past. Selecting the right types of funds, allocating your assets appropriately, making regular investments and evaluating your portfolio can all contribute to creating a more organized investment strategy.

Explore market insights and investment-related tools to support your financial research with Aetram.

Frequently Asked Questions (FAQs)

1. How many mutual funds should I have in my portfolio?
There is no fixed number of mutual funds suitable for every investor. The focus should be on selecting funds with distinct investment strategies and avoiding unnecessary overlap.

2. Can I build a diversified mutual fund portfolio with a small amount?
Yes. Investors can start with amounts that fit their budgets, depending on the minimum investment requirements of the selected schemes. The focus should be on suitable asset allocation and consistency rather than investing a large amount immediately.

3. Are equity and debt mutual funds enough for diversification?
Equity and debt mutual funds can provide exposure to different asset classes. However, the appropriate combination depends on your financial goals, risk tolerance and investment horizon.

4. How often should I review my mutual fund portfolio?
You can review your portfolio periodically, such as once or twice a year and whenever your financial goals or circumstances change significantly. Frequent changes based on short-term market movements may not be necessary.

5. Does diversification guarantee returns?
No. Diversification can help manage concentration risk, but it cannot eliminate market risk or guarantee profits. Different investments can still experience losses under certain market conditions.

Disclaimer: This article is for educational purposes only and is not financial, investment or legal advice. Mutual fund investments are subject to market risks read all scheme related documents carefully. Tax rules are subject to change. Aetram Trades Pvt. Ltd. Is a SEBI-registered stock broker and an AMFI-registered Mutual Fund Distributor (ARN-281894).