How does Mutual Fund Diversification work?

Investing in mutual funds has become increasingly popular among individuals seeking to grow their wealth over the long term. 

While mutual funds offer a variety of benefits, one aspect that cannot be overlooked is diversification. 

Diversifying your mutual fund portfolio can play a crucial role in managing risk and maximizing returns. 

In this blog post, we will delve into the importance of mutual fund diversification and explore its advantages to investors.

What are Mutual Funds?

Before we jump into diversification, let’s understand what mutual funds are.

Imagine you and your friends putting your money together to buy a bunch of different board games to play with. That’s like a mutual fund! It’s a pool of money collected from many people (investors) to buy a bunch of different stocks or bonds.

Mutual funds offer a wide range of investment opportunities. According to an article in Reuters, money going into Indian stock mutual funds increased a lot in June 2023, more than doubling to 86.37 billion rupees ($1.05 billion) compared to the previous period.

Understanding Diversification

To explain in simple terms, diversification is like having a bunch of snacks in your lunchbox instead of just one.

If you have only one snack, and you don’t like it, it is likely that you’ll be hungry. But if you have lots of different snacks, you’ll always have something tasty to eat! When you apply this concept to mutual funds, you have diversified funds.

In the same way, diversifying your mutual funds means Fmuspreading your money across a wide range of asset classes llike individual stocks and bonds, real estate etc.

This helps protect your money from big ups and downs in the stock market. It’s like having a safety net for your savings!

How to Diversify Your Mutual Funds

Choose different types of mutual funds

Before investing in mutual funds, it’s important to consider your risk profile to ensure that the chosen funds align with your comfort level regarding potential investment risks.

There are many types of mutual fund schemes out there. Some invest in big companies, some in small ones, and some focus on specific industries like technology or healthcare.

By picking a mix of these different funds, you’re already starting to diversify! Also, keep in mind that you will also have to pay the expense ratio. The expense ratio is like a small fee you pay for managing your mutual fund investments.

Spread your money across different sectors

It is common advice to ask a beginner mutual fund investor to spread his/her investments in different asset classes.

Just like you there are different subjects in school, the stock market has different sectors like technology, healthcare, finance, and more.

But, also try to spread your money across these different sectors. If one sector is not doing well, your money in other sectors can help balance it out.

Look for Global Exposure

Countries around the world have different economies. By investing in mutual funds that include international companies, you’ll have exposure to businesses from all over the globe.

This can be smart because while some economies might struggle, others may be doing well.

Balance Between Stocks and Bonds

Stocks are like adventurous roller coasters, and bonds are like a gentle swing. Having both in your mutual fund mix can be smart. When the stock market is soaring, bonds might not do much, but they can be helpful when stocks are down.

Regularly Check and Adjust

Just like you update your gaming app, you should review your mutual funds from time to time. Some funds might grow a lot, while others might not be doing as well.

You can keep your diversification on track by checking and adjusting your investments.

Mutual funds that consider market capitalization allocate investments based on the size of companies, aiming to capture growth potential from both large established firms and smaller, emerging ones.

Benefits of Diversification

Lowering Risks

Diversification spreads the risks, so if one investment goes down, it won’t hurt all of your money. It’s like not putting all your toys in one basket! When you know your risk appetite as an investor, you can invest in diverse fund categories.

Diversification in mutual funds helps spread out investment risk, including credit risk.

Smoothing Out the Ride

Mutual funds provide a way for investors to access a diversified portfolio of assets at a relatively low cost. The stock market can be a wild roller coaster. Diversification helps make the ups and downs smoother. This way, you won’t feel queasy when the market has a tough day.

Increasing Chances for Growth

By investing in various companies and sectors, you have a better chance of earning money over time. It’s like planting seeds in different soil – some might grow faster than others, but you’ll have a beautiful garden!

Why is Diversification important? 

If you’re a beginner investor, we’re sure you might have heard from experts about the importance of diversification. Let’s understand this a little deeper: 

Spreading Out Risk

Diversification is super important for beginner investors. As mentioned before, it means not putting all your money in one place.

When you invest in different things like stocks, bonds, and other stuff, you don’t get hit hard if one investment does badly. If one investment product loses money, the gains from others can help balance it out. So, you can spread your investment across different asset classes like equity mutual fund, hybrid fund, small-cap fund, etc.

This way, if the market gets bumpy, your investments won’t get hurt as much.

Enhancing Returns

Diversification isn’t just about being safe, it can also make you more money.

When you spread your money across different things like different types of companies or places, you have more chances to make money. Some funds do well when others don’t, so your overall returns can be better.

Having a mix of different investments can help you earn money in the long run.

Asset Allocation

Diversification also helps you pick where to put your money. It’s like having different teams on your side.

You can choose how much to put in stocks, bonds, and other stuff based on what you want to achieve and how much risk you’re comfortable with. Being aware of your risk appetite is important to ensure that you do optimum asset allocation.

This way, your investments match your goals and how much risk you’re okay with.

Reduced Volatality

The investing world can be bumpy. But diversification can make the bumps less scary.

Different things act differently when the market goes crazy. For example, when stocks drop, bonds might not drop as much.

By having different things in your investments, you can make the ups and downs feel less extreme. This can help you get steadier returns over time and feel better about your investment.

Access to Different Market Segments

Diversification with mutual funds helps regular investors tap into different parts of the market that can be hard to reach on their own.

These funds spread your money across many kinds of things, like different types of stuff you can invest in, different parts of the economy, and even different places in the world.

By doing this, you can try to make money from various markets while also making sure you’re not putting all your eggs in one basket.

This also makes investing easier because you can invest in many parts of the market all at once with just one mutual fund.

What are the different types of Mutual Funds?

Here’s a breakdown of three types of diversified mutual funds: hybrid funds, multi-cap funds, and value funds:

Hybrid Funds (Balanced Funds)

Hybrid funds are a mix of stocks, bonds, and cash. They aim to balance making money and generating income. A fund manager decides how much of each to invest in based on the market and goals.

Hybrid fund suits people who want to lower risk with a variety of investments while still having a chance for growth.

Multi-Cap Fund

Multi-cap funds put money in different-sized companies – big, medium, and small. The fund manager can change where the money goes based on what seems promising in the market.

These funds give you lots of different types of company investments, which is good if you want to spread risk.

Value Funds

Value funds pick stocks that the market is undervaluing. They look for companies that have solid foundations but are currently not popular among investors.

Value funds hope that these stocks will grow in value over time as the market realizes they’re worth more.

Remember, how these funds work can be different, so be sure to read about them before investing. Think about what you want to achieve with your money and how much risk you’re okay with. You might also want to talk to a financial advisor to help you decide which funds are best for you.

It’s important to note that the performance and characteristics of these diversified mutual funds can vary.

Before investing, carefully review the fund’s prospectus, including its investment strategy, risk factors, and past performance. Additionally, consider your investment goals, risk tolerance, and time horizon to choose the most suitable option for your financial objectives.

Consulting with a financial advisor can also provide valuable guidance in selecting the right diversified mutual funds for your investment portfolio.

Conclusion:

Diversification is a fundamental principle of successful investing, and it holds true for mutual funds as well. 

By spreading risk, enhancing returns, facilitating effective asset allocation, reducing volatility, and providing access to different market segments, mutual fund diversification empowers investors to build robust portfolios. These diversified portfolios can weather market uncertainties and deliver long-term growth.

Remember to evaluate your investment goals, risk tolerance, and time horizon before diversifying your mutual fund holdings, and consider seeking professional advice to create a well-diversified portfolio tailored to your needs.