Diversification is an essential part of investing
It is generally advised ‘not put all the eggs in one basket’ when it comes to investments. Distributing risk across various baskets – or asset classes - will reduce the achievable gains in one basket, but importantly lowers the risk of losing all the eggs due to an adverse event. This underlying idea forms the basis of portfolio diversification. In this article, we explain the benefits of a diversified mutual fund portfolio.
Understanding diversification better
Diversification works, because all asset classes do not behave the same way. That is, they move in the same direction in response to changing investor sentiment. Historically, it has been seen that, whenever the sentiment for equities strengthened, investors pulled out of safer assets, such as debt, and moved into stocks to capture gains. When equities pass through a bear phase, risk appetite takes a hit, and demand for safer assets and commodities, such as gold, rises.
Chart 1: Performance of various asset classes in India across bull and bear market phases
Source: CRISIL Research
As can be seen in Chart 1, gold (represented by the CRISIL Gold Index) and debt (represented by the CRISIL Composite Bond Fund index) rallied during the sub-prime, European, and Chinese crises (market phases, which witnessed declines in equities). In the post-crisis periods, stocks (represented by the Nifty 50 index) outperformed bonds and gold. Because of this inverse relationship between the asset classes, investing in a portfolio of diversified holdings reduces the risk associated with investing in a single asset. In other words, losses in one asset class are offset by gains generated by other assets.
Illustration: Portfolio impact of diversification over short- and long-term periods
To highlight the benefits of diversification, we have taken three portfolios (Chart 2): (1) a pure equity portfolio; (2) a portfolio with 50% in debt and the rest in equity; and (3) a portfolio of assets equally distributed among equity, debt, and gold. Weighted daily returns of the indices were used to represent fund allocation in an asset class.
Below are the descriptive statistical indicators of the three portfolios over 3-, 5- and 7-year rolling periods since March 31, 2002 (inception date of the CRISIL Composite Bond Fund Index) . As can be seen, diversifying across asset classes not only provides stable returns, but also drastically reduces the volatility of a portfolio.
Chart 2: Risk and return of portfolios at different diversification levels and time frames
Source: NSE, LBMA and CRISIL Research
Note: Equity is represented by the Nifty 50 index and debt by CRISIL Composite Bond Fund Index. The gold price index has been created by taking the product of LBMA gold prices and the rupee exchange rate.
Diversify a portfolio through mutual funds
Now that we have set the premise that diversification is important, let us look at how mutual funds and their various categories are an ideal way to spread a portfolio.
Investors can allocate money across individual mutual fund categories or look at investing through hybrid/multi-asset allocation funds for investment. For instance, in equity, investors have large-, small-, mid-cap and diversified mutual fund schemes. On the debt side, there are long- and short-maturity debt funds. Further, for exposure in gold, there are gold ETFs and funds. Investors can choose the mutual fund categories based on their risk-return profile and investment horizon (Table 1).
Table 1: Mutual fund scheme categories for varying risk profiles and time horizons
Every investment goes through ups and downs. Thankfully, investments that take exposure to different asset classes usually do not fare poorly at the same time. Mutual fund schemes, through exposure to a diversified portfolio, help investors reap optimal returns across market phases.
- Evaluate your financial goals and the time to attain those goals.
- Consider your risk tolerance. Ask yourself if you would be comfortable with a sharp fall in the value of your portfolio.
- Consider the various costs associated with the scheme, such as the expense ratio.
- Hastily picking up a scheme that is doing well currently, in an attempt to reap short-term benefits. Research the fund houses’ offerings thoroughly.
- Investing without guidance, if you’re not sure which fund is right for you. Seek the help of a financial advisor.
Disclaimer : Any information contained in this article is only for informational purpose and does not constitute advice or offer to sell/purchase units of the schemes of SBI Mutual Fund. Information and content herein has been provided by CRISIL Research, a Division of CRISIL Limited, and is to be read from an investment awareness and education perspective only. The views / content expressed herein do not constitute the opinions of SBI Mutual Fund or recommendation of any course of action to be followed by the reader. Investors should consult their financial advisers before taking any investment decision.
Mutual Fund investments are subject to market risks, read all scheme related document carefully.