Diversification in Mutual Funds, Explained Simply

Every investment carries risk. A single company can run into trouble, a sector can fall out of favour, and a whole market can drop. Diversification reduces the damage from any single problem by making sure no one holding is too large a part of your money.

It does not remove risk completely. When the entire market falls, most equity holdings fall together. But it greatly reduces the risk of a permanent loss from one bad choice.

When you buy a diversified equity fund, your money is spread across many companies, often across many sectors. If one company fails, it is only a small part of the fund.

Compare that with buying a few shares directly, where one bad pick can hurt badly. Our page on mutual funds versus stocks explains this difference.

Different equity fund categories behave differently. Large cap funds are usually steadier, while mid and small cap funds can grow faster and fall harder. A flexi cap fund can move between them.

Holding a mix of categories, rather than only one, can smooth the ride. Our page on large, mid and small cap funds explains the differences.

Equity, debt and gold tend to behave differently. When equity markets fall, high-quality debt often holds steady, and gold sometimes rises. A portfolio with all three usually swings less than one with only equity.

How much of each depends on your goals and time frame. Our page on asset allocation explains how to decide.

A SIP invests a fixed amount every month, buying at high prices and low prices over the years. This spreads your entry across many market levels, so you are not hurt by putting everything in at one bad moment.

Our page on rupee cost averaging explains how this works.

Some investors also hold international funds, so that not all their money depends on the Indian economy. This can reduce the effect of a local slowdown, though it adds currency movements.

Our page on international funds explains the options and their limits.

Many investors think more funds means more safety. But ten equity funds often hold many of the same large companies. You end up with something close to an expensive index fund, with more paperwork and harder tracking.

Our page on portfolio overlap explains how to check whether your funds are really different.

For most families, a handful of funds across the right categories is plenty: perhaps one or two core equity funds, a debt fund for stability, and optionally a smaller holding in another category or gold.

The exact number matters less than whether each fund has a clear job. Our page on how many funds to hold explains this in detail.

Some people worry about keeping all their money with one fund house. Mutual fund assets are held by an independent custodian and are separate from the fund house own money, so a fund house running into trouble does not mean your investments disappear.

Spreading across two or three fund houses can still help diversify investment styles. Our post on what happens if a fund house shuts down explains the safeguards.

A sector or thematic fund puts all its money into one area, such as banking, technology or defence. That concentrates risk. If the theme falls out of favour, the fund can lag for years.

If you use them, keep them small. Our page on sectoral and thematic funds explains the risks.

Diversification works best when it follows your goals. Short-term goals need steady debt funds. Long-term goals can use a mix of equity categories. Each goal can have its own small, diversified set of funds.

Our page on how to set financial goals explains how to match funds to goals.

Over time, the part of your portfolio that grows fastest takes up more space. After a strong equity run, you may hold far more equity than you planned. Once a year, bring the mix back to your plan.

Our page on portfolio rebalancing explains how.

• A flexi cap or index fund for broad equity exposure.
• A hybrid or multi asset fund for equity, debt and sometimes gold in one place.
• A debt fund for stability.

Our pages on hybrid funds and index funds explain these options.

Imagine a family with three goals: an emergency buffer, a child college fund twelve years away, and retirement twenty years away. The buffer sits in a liquid fund. The college fund uses a flexi cap fund and a hybrid fund. The retirement money uses an index fund and a flexi cap fund, with a small gold fund alongside.

That is five or six funds in total, each with a clear job, spread across asset classes and company sizes. It is diversified without being cluttered. This is an illustration, not a recommendation.

• Most of your money is in one fund or one category.
• You hold several funds from the same category with similar top holdings.
• Almost everything is in equity, even money needed within three years.
• A large part sits in one sector or theme.
• All your savings are in property or deposits, with nothing in growth assets.

If any of these sound familiar, a review could help.

• A fund already diversifies across many companies.
• Mix asset classes to match your goals.
• A few funds are enough; too many overlap.
• Rebalance once a year.

We are distributors rather than investment advisers and we recommend no schemes. If you want help checking whether your portfolio is well diversified, get in touch.