Tips For Ideal Portfolio Diversification

By | March 11, 2017

Tips For Ideal Portfolio Diversification

Have you ever heard of the saying, “Don’t put all your eggs into one basket?” This perfectly sums up the importance of portfolio diversification when you begin investing money.

Having a diversified portfolio of investments is very important to gain positive, inflation-adjusted and risk-adjusted returns.

Additional Reading: How Important Is A Well-Diversified Portfolio?

But, how many Mutual Funds are considered ideal in a diversified portfolio? Defining an ideal number of Mutual Funds to have in your investment portfolio is dependent on a few specific factors. Let’s decode these factors for you with these questions.

What Is Your Investment Objective?

What purpose does your investment portfolio serve? For many investors, the main objective of investing is to create long-term wealth or build a retirement corpus, while some investors may look at their investments as a source of regular income.

On the other hand, certain investors are more conservative and wish to preserve their money, opting for capital safety over growth or risk.

Once you set your investment goals, you will be able to decide a suitable asset allocation for your investments.

Additional Reading: Intelligent Asset Allocation

What Is Your Risk Tolerance?

Risk tolerance is a rather common term in the world of investing. It is a measure of an investor’s comfort with market volatility on his investments. This defines how you react to periodic fluctuations in the markets. Ask yourself how much risk can you handle without losing sleep over your investments.

If you are the adventurous sort of investor, you will be willing to hold tight to your investments in volatile Mutual Funds during a bear market.

Additional Reading: Evaluating Risk Tolerance And Appetite

If you are unsure of your risk tolerance, we are here to help you with a simple risk tolerance questionnaire.

A Risk Tolerance Questionnaire?

A Risk Tolerance Questionnaire is usually used to assess an investor’s level of comfort with the effect of market risk on his or her money. A Risk Tolerance Questionnaire categorises investors as aggressive, moderate, or conservative. Take a shot at the Risk Tolerance Questionnaire and find out where you stand.

Additional Reading: All About Risks In Debt Funds

  1. You wake up one day to find that the stock market has crashed by 10%. Your investments are down by 15%. Do you
    1. Sell all your investments?
    2. Contact an investment advisor to check if you need to sell any of your investments?
    3. Wait for a few days to see if the market will recover?
  1. You have invested in stocks and equity Mutual Funds to buy a house. Your goal is 2 years away. Your investment advisor says markets might go up this year. Do you
    1. Move your investments to safer avenues right away?
    2. Wait for a year to move your investments to safer avenues?
    3. Hold on till your investment advisor says it is okay to move your investments?
  1. You invested a large amount of money in a penny stock. The stock has sunk by 15%, but you know that the company is a strong one and will do well in the long run. Do you
    1. Sell the investment anyway?
    2. Wait for a few days to find out how bad the news is?
    3. Hold on to the stock?
  1. During a market slump, do you
    1. Sell loss-making investments?
    2. Check to see if you can buy good stocks at low prices?
    3. Add more stocks to your portfolio?
  1. You invest in Equity Mutual Funds based on
    1. What your investment advisor tells you
    2. What your friends tell you.
    3. Your own research.

Decoding Your Responses To The Risk Tolerance Questionnaire

If you have attempted to answer the Risk Tolerance Questionnaire we put together for you, we can tell you which type of investor you are.

If you chose option ‘1’ for most or all of the questionnaire’s questions, you are probably hesitant about experimenting with your money and you prefer to put as much distance as you possibly can between your money and market risks. You are a conservative investor.

If you chose option ‘2’ for most or all of the questionnaire’s questions, you are probably not completely risk averse. You don’t lose too much sleep over minor market fluctuations and are open to taking a moderate level of risk with your investments. You are a moderate risk investor.

If you chose option ‘3’ for most or all of the questionnaire’s questions, you probably pride yourself on being an expert on everything about investments. You are an adventurous sort of investor and are not afraid to take considerable risks with your finances. You are an aggressive investor.

Additional Reading: How To Be A Successful Investor

Consider Risk Capacity Too

Risk tolerance is all well and good, but it may be rather unwise to take unnecessarily high risks with your investment corpus just because you want big-ticket returns.

But, hang on! You seem to be forgetting your risk capacity.

Risk Capacity? Oh, No! What’s That?

Risk capacity is simply the level of risk you can comfortably afford to take on your investments. You may be willing to shoulder high risk, but if your investment goals are close at hand, or if your investments are for the short-term, you will do better to tone the risk factor down and opt for a more conservative portfolio.

Additional Reading: Estimate Mutual Fund Risk

What Types Of Mutual Funds Will You Need In Your Investment Portfolio?

If you have a relatively moderate-to-low risk appetite, it is advisable to invest in at least three or four Mutual Funds that cater to various investment objectives.

For instance, in a sinking bear market, Equity Mutual Funds may decline rapidly, but Debt Funds may perform better and sustain in value. Debt Funds may even see growth opportunities in a bear market.

Additional Reading: Introduction To Equity Mutual Funds

On a primary level, there are two main Mutual Fund categories – Equity Mutual Funds and Debt Mutual Funds.

The simplest way to understand the objective of diversification is to invest in two different types of Funds – Equity Funds and Debt Funds, in order to balance out the level of market volatility.

If you find that you may need access to your invested money at short notice, investing in Liquid Funds is a good option.

If you have a moderate or high-risk appetite and are aiming at achieving long-term growth with your investments, you will need to invest your money more in Equity Funds and less in Debt Funds. Why? It’s simple. Equity Mutual Funds have a higher potential for better returns over the long term.

Additional Reading: FYI On Equity Diversified Mutual Funds

How Much Money Do You Have To Invest In Mutual Funds?

It’s time to bust the myth that says investing in Mutual Funds requires you to have a large sum of money. That couldn’t be further from the truth. Mutual Funds have a low minimum investment threshold. In fact, it’s as simple as opening a Savings Account, only much more rewarding. You can begin investing in Mutual Funds with as little as Rs. 500.

Additional Reading: 10 Benefits Of Investing In Mutual Funds

Let Us Get You Started With Portfolio Diversification

Building a successful investment portfolio is easy and not the herculean task some might make it out to be. It would be wise for you, as an investor, to create your own investment portfolio and manage it based on your specific financial needs. Here’s how you can do that.

Ever heard of the core and satellite model of investing? This is simply a two-section investment portfolio. The core generally consists of large-cap Equity Mutual Funds and will make up the bulk of your investment portfolio.

Now, once the core section is created, you build the satellite section around the core. The satellite will represent the smaller portions of your investment portfolio.

Need an example of a suitably diversified investment portfolio if you are a moderate risk-taking investor? Check this out:

  • Large-cap Equity Mutual Funds: 40%
  • Small-cap Equity Mutual Funds: 10%
  • Stocks: 15%
  • Intermediate Term Bonds: 30%
  • Cash / Money Market Funds: 5%

This allocation is appropriate for an investor who is willing to remain invested for the long-term and has a moderate risk tolerance.

Simply put, the asset allocation is 65% in equities, 30% in debt instruments and 5% in cash and money market instruments.

Additional Reading: Tips For A Healthy Asset Allocation

So How Many Mutual Funds Is Ideal?

It is possible that the ideal number of Mutual Funds you should invest in for a well-diversified portfolio is between three and five funds.

It is not absolutely necessary to have more than ten different Mutual Funds in your investment portfolio.

Investing in Mutual Funds is easy and can be highly rewarding. Make a wise choice. Start investing today.

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Category: Mutual Funds

About Dheeraj Kapoor

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