Diversify your portfolio. Don’t invest in just one asset class. Don’t put all your eggs in one basket.
You might have heard some version or other of the above statements, while you were trying to invest. These are valid pieces of advice.
It is a good practice to diversify our portfolio by investing in different asset classes. For example: you could diversify your portfolio by investing 30% in debt and 70% in equity based mutual funds. Within Equity, you could diversify further by investing in Large cap, Mid cap, Small cap etc. Further you could diversify Large cap by investing in sector based funds. Each of the above mentioned categories has different nature of returns and volatility.
Diversification works differently for different asset allocations, but the underlying principle is the same: If one category underperforms, you could still get decent returns on your overall diversified portfolio. It does not necessarily increase the overall returns. But it reduces the risk in the long term.
While diversification sounds great on paper, many of us make a big mistake: We over diversify i.e., we buy too many mutual funds in the same asset class that does not necessarily diversify our portfolio.
For example, when I was new to the investment arena, I had seven mutual funds SIPs in Equity alone. On close examination, I found out that they invested in more or less the same set of companies. This diluted my returns while simultaneously increasing my cost of funds. When the entire category was going through a bad phase, my portfolio took a hit, even though I had seemingly diversified my portfolio.
On that note,
- Less than 3 mutual funds
- 4 to 6 mutual funds
- 7 to 10 mutual funds
- More than 10 mutual funds