Diversification is looked upon as one of the best strategies for risk management when investing. When considering opting for mutual fund investments, spreading allocations across asset classes, sectors, and geographies can reduce the negative impact of poor performance in any one area. The following is a step-by-step guide to creating a diversified mutual fund portfolio aligned with investors’ goals to reduce risk.
1. Understanding risk tolerance and investment objective
Investors should be aware of their risk tolerance level, investment horizon, and goals before investing in mutual funds. Diversification works well when tailored to individual needs. For instance, a young investor with a long-term financial goal can invest heavily in equity mutual funds for growth. In contrast, a conservative retail investor close to retirement age may prefer debt funds for capital protection or stability.
2. Investing across distinct asset classes
A diversified portfolio balances out exposure across distinct asset classes:
- Equity funds: Invest in shares and offer great growth potential with higher risk. Include large-cap funds for stability, mid-cap funds for growth, and small-cap funds for higher risk-reward opportunities.
- Debt funds: Invest in fixed-income instruments i.e., bonds. Why? Because they offer regular returns with reduced risk. For attaining short-term goals, debt funds, such as low-duration or short-duration funds, are recommended. This can help manage changing interest rates.
- Hybrid funds: Combine equity and debt together to provide a well-balanced approach. Aggressive and balanced funds under the category of hybrid funds act as a middle ground.
3. Diversify within and across sectors
Invest across multiple sectors to avoid any kind of overexposure to any one industry. Sector-specific funds can complement a core portfolio. Also, invest in domestic and international mutual funds to access global markets, which often perform differently under differing economic conditions.
4. Choose funds with sound fundamentals
Select a mutual fund based on these key parameters:
- Expense ratio: Lower fees mean higher returns for investors. Aim for funds with an expense ratio below the category average.
- Fund manager track record: Prefer an experienced manager with a consistent track record.
- Asset Under Management (AUM): Mid-sized AUM funds tend to balance stability and flexibility.
- Past performance: Past returns do not guarantee future results but can be compared against peers and benchmarks.
5. Periodic rebalancing
Market fluctuations may shift your portfolio away from target allocations. Rebalance annually when any asset class deviates 5% to 10% from its initial allocation. This involves selling outperforming assets and purchasing underperforming ones to maintain balance. For example, if equities grow to 70% of your portfolio from an initial 60%, reduce equity exposure by reallocating to debt or hybrid funds.
6. Use planning tools
Use a lump sum calculator to calculate potential returns from a one-time investment. For regular investments, an SIP calculator estimates growth over time. These tools help ensure investments align with financial goals such as buying a house or planning for retirement.
7. Remain disciplined and long-term oriented
Diversification is a long-term strategy. Avoid chasing market trends and stick to your asset allocation unless your financial goals or risk tolerance change.
8. Consult a financial advisor
If unsure or overwhelmed, seek help from a qualified financial planner to create a tailored investment plan based on your unique situation.
Conclusion
Diversification is essential for a strong mutual fund portfolio. Combining stocks, bonds, and hybrid funds, spreading investments across sectors and markets, and periodically adjusting your portfolio helps control risk.
Building a successful mutual fund portfolio requires patience, discipline, and thoughtful planning to achieve steady returns while protecting your money from market ups and downs.