You've done your budgeting and understood your financial goals.
Analyzed your risk-taking appetite, and defined what you want your money to do for you. Based on this you've even established a portfolio blend of stocks, bonds and cash - asset allocation.
But what next?
Now you simply need to maximize your returns in every asset class by choosing the right investments.
Not only good investments but an assortment of investments that work well with each other.
Ways to diversify
Diversify across investments:
By choosing to invest in mutual funds instead of stocks you are already a step ahead. Mutual funds by their very nature of formation expose the investors' money to diversification. They protect the investments from concentration risk by picking 20-30 stocks and expose your portfolio to different stocks from various sectors.
Across asset class:
Some argue that emerging/developed markets, Gold and real estate are also asset classes that should be considered. But by far Bond, Stocks, Cash are the most widely accepted asset classes. Mainly because they exhibit distinct characteristics. The mix you choose is determined by your risk appetite and your return expectations.
Stocks/Mutual Funds Bonds Cash (Saving account)
Return High Medium Low
Risk High Medium Low
Ideal for Age group 20-45yrs 45yrs and above
Simply put, someone who is probably in their 30s,40s can absorb more risk and should tilt their portfolios more towards Stocks and Equity Mutual funds. Whereas, someone much older looking for a fixed monthly income should invest largely in Bonds.
Across sub-asset class:
Don't just invest in different stocks but stocks from different sectors. Sectors that are not co-related.
Sectors can be segregated depending on their nature/ reaction to different market scenarios- defensive and cyclical.
For instance, we invest in 3 different stocks: Bajaj Auto, HPCL and HDFC Ltd.
All from different sectors, right? Not really.
Unknowingly, we have exposed our entire portfolio to sectors that react the same way. For instance, they will all be impacted negatively by an economic slowdown.
We could add the right kind of stocks like Hindutan Unilever, Nestle India or NTPC Ltd. They will act as a perfect hedge against the stocks in the cyclical sectors mentioned above. Slowdown or not, we will eat, brush our teeth, use detergent to wash our clothes etc.
Another sub category to consider is size. This applies to mutual funds as well as stocks. Just adding a bunch of stocks and mutual funds mimicking the same index will not help you diversify. Depending on your risk profile add some from Large caps and small caps categories as well.
Mutual Funds Stocks Bonds
Equity - Diversified Sectoral Short term
Equity - Sector based Small cap Intermediate term
Equity - Small Cap Large cap Long term
Equity - Mid cap Mid cap
Equity - Large Cap
Beware of overdiversification - Chose quality over quantity
It is a lot like the marginal utility concept of economics we learn in school.
Every single additional investment added to the portfolio lowers the risk-by a smaller and smaller amount. Simultaneously, it also lowers our expected return.
You don’t need too many funds and stocks in your portfolio. But how can you tell?
Every time you add a stock to your portfolio make sure you glance through their historical returns data. Especially in co-relation with your existing stock portfolio. If you notice a trend where they all fall and rise at the same time you are probably exposing your portfolio to the risk over-diversification.
Don't get overwhelmed by all of this. Not everyone needs to have all flavors of funds, stocks and bonds in their portfolio. Keep it simple. Analyze the ones that are best suited to your needs based on your return expectations and risk appetite and stick to them. Make sure they don't overlap.
When it comes to Funds, you don't need 10 different ones in your portfolio. Investing in 3 to 5 Mutual funds will help you achieve diversification. But make sure they don't all belong to the same category and reflect your risk and return expectations well.