Mutual Fund Portfolio: Importance of portfolio Diversification
Created on 11 Jun 2020
Wraps up in 6 Min
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Updated on 26 Aug 2020
Ever thought of putting all the eggs into one basket and expected a miracle to happen? We all do, right! High dividends allure us, and so does investing in the top-performing companies. But the golden eggs don't create a shiny basket at times! And here it is the red flag that we are talking about. Imagine the tragedy; you invested in equity for a short period, Debt for the long-term. See, you are already bewildered after reading the last sentence and saying, what was that? This brings me to my next question, how do we know that we have the best portfolio if something called perfect, ever existed in reality. Wait, before we proceed, let's get to know what a portfolio is.
What is Portfolio
A portfolio accumulates financial assets such as stocks, bonds, commodities, paper money, and fund complements, including mutual, exchange-traded, and closed funds. A sentence looks tough when we read it in a single go. But when we break simpler words into prefixes and suffixes, it becomes readable. Similarly, if we diversify our portfolio properly, we would receive quality results. Blend; Equity & Debt & Equity-
Now, when we talk about the blend, we need to understand the kind of required blend and its purpose. Taking duration and volatility factors also into account. The debt-to-equity ratio is a financial ratio that indicates the relative proportion of shareholders' equity and Debt used to finance a company's assets. If a person is not an aggressive investor and wants a short-term return, he can invest in equity because they plow back well in the long-term, and we can invest in Debt for a short period as they are a risk-free financial instrument. Also, the debt-to-equity ratio is closely related to risk ratio. An investor can also invest in the blend according to his needs. Talking about risk, it represents the deviation in chances of earning profit against its face value.
A mutual fund is a financial instrument created by accumulating a pool of money collected from various investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional portfolio managers, who allocate the fund's assets and generate capital gains or income for the fund's investors. A mutual fund portfolio is created and maintained to match the investment objectives stated in its prospectus.
Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds offer investment in a vast number of securities, and performance is usually tracked as the change in the total market capitalization of the fund derived by the aggregate performance of the underlying investments. Now that we have clarity about the concept of a mutual fund, we should further dive into the other essential factors that lead to making up a stable and realistic basket.
Mutual Fund Diversification
As stated above, an investor should not put all his eggs in a single basket. It implies that, if we put all the high yielding financial assets in a single portfolio, we might not get expected results as we have created the basket of expectations and fortune 500, top 100 gainers, etc., for the portfolio. We can not expect to put all the Dairy Milk chocolates in a basket and expect it to taste different each time we consume it; Portfolio overlap. So, to earn separate returns and safeguard ourselves from the trap of falling in this egg accumulation, we must diversify our portfolio.
But the vital question arises, can we make a portfolio just like that? Is there any pre-requisite objective setting to it? Diversifying will help? Can diversify help in reducing risks and increasing returns? How to diversify? The answer is no to first and yes, to all the questions. Further discussion would clarify all the doubts in your clouded mind.
A portfolio can not be made just like that. To build a portfolio from scratch, we need to do financial planning, the reason behind in the long-term or short-term duration dividend-to-be-received. For setting up the plan, we need to define our objective. For example, your daughter's marriage in the next ten years, son's abroad education in the upcoming five years.
We have objective and financial planning to invest proportionately in various stocks, government bonds, and funds.
Diversification helps to spread and reduce the risk, provides us with a variety of financial assets, and reduces the portfolio risk to a certain noteworthy extent. But over-diversification is a big NO; it would lead to the nearly lowest amount of dividends a person could receive.
A stable portfolio should consist of large-cap, mid-cap, and multi-cap stocks. The amount of investment in terms of volume is also dependent upon the risk profile of the investor. If you're not an aggressive investor, but still you invest your money in a risky financial asset, it might not give you the expected return, and this will lead to you another pocket draining situation. So, after knowing your goals and risk profile, you must be aware of multi-bagger stocks and not fall for absolute but rolling returns.
The difference between absolute and rolling returns states that absolute returns give you an on the surface idea, which might not be realistic as it might not be able to beat the inflation-adjusted return at the moment, and so does risk and return associated with it. Whereas rolling stocks give you an idea for a specific period. For example, you looked at an ABC company's returns, which showed 40% absolute returns for the past ten years. When you see its rolling returns, it says-
2010-2014 = 30%
2014-2018 = 25.5%
2018- till now = 35%.
So, the investor who invested in the year 2017 faced losses in comparison to the 2013 investment. Therefore, rolling returns gives you a realistic idea of where to invest according to the economic conditions, schemes, and policies.
It is remarkably essential to understand that diversification is not a game of quantity returns but about investing across a spectrum of companies, sectors, and asset classes by using mutual funds as the instrument.
Don't add-to-cart in your portfolio because your friend suggested you do so, or you saw it in the news that it is a performing stock to load your portfolio with. Over-diversifying also increases the trouble of tracking their performance, which is an essential activity. Also, there is no perfect mutual fund Portfolio for diversification.
Monitoring the performance of the existing funds in your mutual fund portfolio is a must. When you observe some of the funds are weighing your portfolio down, stop investing in them and select better funds in the same category that serve your need. Nevertheless, these may be just a matter of a business cycle, and returns may reiterate in the coming times.
Remember, no matter how diversified a portfolio may be, it can never mitigate risks entirely or at 100%. Bear in mind that if you want high yields, you'll have higher risks associated with it too.
Even diversified investments are subject to market risks.
To maintain the flow of dividends and return from the scratch of your portfolio, you must consider diversifying underlying financial assets and aligning them with your financial plans and objectives and rolling returns. It would be best if you considered your risk profile assessment for building a portfolio from scratch. A perfect portfolio is a basket where you get all your requirements fulfilled without overlapping a portfolio. Thus, now you know how to put which egg into your basket rather than putting all the eggs in the same basket.
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