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Diversification helps reduce risk. The benefits of diversifying one’s portfolio are, of course, known to all. It helps align our investment portfolio with our financial-cum-risk profile. It protects us from any downside in one particular asset class.
As each one of has a unique financial-cum-risk profile, each one of us must:
Build a suitable mix of investment across various assets classes viz. debt, equity, real estate, gold etc.
Even among the broad asset class like debt or equity, there are sub-classes. One must diversify suitably across these sub-classes too. For example in debt one must invest suitably in Bank FD, NSC/KVP and PPF etc. Or in equity one has to diversify across large-cap, mid-cap, small-cap, sector-specific.
Going further, even within particular sub-class say large-cap equity, one has to choose a mix of individual stocks.
The overall approach is a top-down one i.e. starting from the broad allocation across asset classes, you move down to choosing individual investment options. We could invest separately in each of the individual option as per our desired allocation strategy. This approach gives us the total flexibility to choose what we want. We have full control over our financial decisions. But this approach:
Can become a bit cumbersome
Requires one to have the time and the knowledge to identify and invest separately in individual opportunities.
A fairly large corpus is needed to achieve the desired diversification
The transaction costs could work out to be high
The tax efficiency is low
Mutual Funds offer some simplification and tax-efficiency, but this so far is limited to equity and debt. We may, however, shortly see real estate and gold funds too. Even within say debt all instruments are not included such as PPF, where we would still have to invest separately. Further, Mutual Funds also offer different routes to achieving the desired diversification. The choice of route usually does not affect the overall returns, which is more a result of the ultimate choice of funds that we make under a particular route. To make the portfolio more suited to our needs and invest across fund houses, we could go in mixed schemes such as MIP or balanced mutual funds. Herein the corpus gets invested in individual stocks and bonds based on the allocation percentage. You could, for example, invest in a balanced fund where 60-65% of the corpus gets invested in individual stocks and the balance 35-40% in different bonds.
In a step further to the previous route, we choose different dedicated equity and debt funds, instead of mixed funds. The benefit of course is higher degree of flexibility to construct a portfolio more in line with our needs. By choosing different funds covering different sectors in the market, we can achieve a high level of diversification across entire market – both debt & equity. But the drawback is a further increase in the number of individual funds we need to invest in and manage. Also, at the time of portfolio rebalancing, we could end-up with a higher tax-outgo.
Given these various routes available, we can choose the one, which suits us the most from the perspective of time, knowledge and efforts that we can devote to managing one’s finances.