Manage Risk Through Diversification Hemant Rustagi Chief Executive Officer, Wiseinvest Pvt Ltd.

Managing risk is one of the key challenges for investors through their defined time horizon. The best strategy to manage the risk in your investment process is to build a diversified portfolio. In fact, a diversified portfolio also helps you to tackle different market conditions. However, to benefit from the true potential of diversification, you need to diversify your portfolio both in terms of allocation to different asset classes as well as within an asset class. While a goal-based investment approach goes a long way in ascertaining the right mix of asset classes in the portfolio, an investment option like a mutual fund allows you to diversify efficiently across different asset classes as well as within an asset class. [EasyDNNnews:PaidContentStart]

Apart from being a diversified investment vehicle, mutual funds offer a variety of funds within an asset class. For example, for the equity portion of your portfolio, you can choose from a variety of funds like those investing in different segments of the market, i.e., large cap, Mid-Cap and small cap, and the ones that allow you to invest in a mix of different segments of the market like multi-cap funds, large and midcap funds, flexi-cap funds. Then, there are index funds, sector and thematic funds as well as value/contra funds. 

Unfortunately, diversification is also an aspect of portfolio building where investors usually follow a haphazard approach. It is quite common to see investors having a large number of funds in their portfolio as they believe it to be the right way to achieve diversification. If you are one of those investors who have built an over-diversified portfolio, you must know that too many overlapping funds would invariably make your portfolio quite complicated. Besides, the failure to weed out non-performing funds can impact your overall portfolio returns negatively. In reality, a few carefully selected funds in your portfolio could provide you a much higher level of diversification and that too without compromising your returns. 

In fact, over-diversification can harm your portfolio in more than one way. For example, investing in a few small cap funds, for the sake of higher diversification, could make you compromise on the quality of the portfolio as stock picking and sound investment process are major differentiators for these funds. Considering that small and micro-cap segments suffer from poor liquidity and limited coverage, it is always prudent to opt for a fund that has a quality portfolio. 

While there is nothing like an optimal number of funds that you need to own to have a sufficiently diverse portfolio, factors like the size of the portfolio and your asset allocation to different asset classes can help you decide that number. You must also consider the level of risk you are willing to take to meet your returns expectations. Risk tolerance should also be addressed from two perspectives: financial risk tolerance and emotional risk tolerance. 

Another important aspect of diversification is time diversification, i.e., remaining invested over different market cycles. It is particularly important when you invest in a volatile asset class like equity. Considering that volatility is a natural phenomenon in the stock market, a systematic investment approach coupled with long-term investing can turn this volatility to your advantage through ‘rupee cost averaging’. Moreover, longer time horizons allow you to take on greater risks, with a greater potential to earn better returns, as some of these risks can be reduced by investing across different market environments. Similarly, if your time horizon is short, you would have greater liquidity need. Hence, the focus should be on investment options that provide liquidity with a reasonable degree of safety of capital. 

As is evident, the length of time you remain invested is important. While time horizon plays an important role in deciding your asset allocation, you must maintain it to get the desired results for your investment goals to be achieved over time. Maintaining asset allocation ensures that you do not miss out on opportunities that keep emerging periodically in the market. Rebalancing the portfolio is another strategy that helps you maintain the right level of diversification in the portfolio. 

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