Important reasons why individuals should have a diversified equity MF portfolio
While mutual funds are a great tool for diversification, many investors think that once they put their money into a mutual fund their work is over, but for a fact this is not the case, their work just starts as even in mutual funds sufficient diversification is required. Diversification basically means investing in a variety of securities so that a failure in a security or an economic slump affecting one of them will not be damaging to your portfolio.
Diversification helps in reducing the financial risk through these 5 ways:
1. Reducing Variance
Variance is a measurement of the difference (spread) between numbers in a data set. The variance measures how far each number in the set is from the mean. Basically, it tells you how risky is your investment and how much volatile is it? Diversification can lower the variance of a portfolio’s return below what it would be if the entire portfolio were invested in the asset with the lowest variance of return, even if the asset returns are correlated. In general, the presence of more assets in a portfolio leads to greater diversification benefits, i.e. lower risk of exposure to loss.
2. Removing Unsystematic risk
In Finance, we are introduced to the concepts of diversifiable and non-diversifiable risk. Diversifiable risk is unsystematic risk, also called as security-specific risk and Non-diversifiable risk is systematic risk which is also termed as beta. For example: If one buys all the funds in the presence one is obviously exposed only to movements in that market. If one buys a single fund in the presence, one is exposed both to market movements and poor performance of a fund based on its underlying company. The first risk is called “non-diversifiable,” because it exists even if many funds are bought, but the second risk is called “diversifiable,” because it can be reduced by diversifying among funds.
3. Balancing out in Risks and Returns
Risks and returns are the outcome of the stock selection done by the fund . The mutual funds are restricted to invest outside the asset class or the sector in which they belongs even at the catastrophic times. This limits the returns and enhance a portfolio’s risk when it only consist a single Mutual Fund. Diversifying a portfolio in various asset class i.e. Large cap, Mid cap, Small cap and Bonds balanced out risk and returns as the investors is exposed to high level of stocks in every asset class of the market.
5 important reasons why individuals should have a diversified equity MF portfolio
4. Overcoming a Fund Manager’s Faux Pas
Every investment bear the possibility of become a success, disaster or somewhere in between, this all depends on the funds manager’s perception and investment style but, nothing works in the market all the time. If something go wrong with the manager’s perception at some time, it could wipe out a non-diversified portfolio. A diversified MF portfolio may save investor from a complete capital erosion when a human error materialize
5. Conquering the timing curse
Higher investments are done when the market is at peek and the investment amount narrowed when the indices plunged. Sentiments encourage investor to invest in the market when the indices climb exposing it to the bad time investing. Investment is a long run process and diversification helps offsetting loses. Diversifying your portfolio not just to the funds but spreading the payments to different times brought the risks lower.