Debt Vs. Equity: Happy Diversification
26 Sep 2019

Debt Vs. Equity: Happy Diversification

If you have been investing in mutual funds, you would know the difference between debt and equity funds. The latter invest in stocks or shares of companies, and the objective is to generate higher returns than debt-oriented funds or fixed income products. These funds generate high returns when the underlying stocks perform well.

On the other hand, debt funds invest in debt products. This is why they carry less risk. and are more likely to give stable returns.

Let us look at what diversification means and why is it relevant to your investment portfolio.

Diversification is a recommended investment practice for designing a portfolio. With this, you spread your investments across different types of assets. It ensures that your exposure to similar types of assets is limited. The idea is simple. Suppose one investment is losing money, the other may make up for that loss. Diversification does not give a guarantee that your investments will always perform exceptionally well. However, it will improve the chances of better returns during volatile markets.

Mutual funds and diversification

While investing in mutual funds, one often faces the debt vs. equity debate. As a mutual fund investor, you should spread your investments. You should invest in both types of funds because it helps you optimise your portfolio and give it variety.

Stock-oriented investments are affected by market movements. During bear markets, equity mutual funds may underperform. Similarly, during volatility, these funds may even give negative returns, affecting your expected returns. Though over time, markets may recover, and you can also recover losses, your personal financial goals may get changed.

This is where debt funds come in; investing in these funds could decrease your chances of incurring a loss. These funds invest in fixed-income securities that are known to be less risky or sensitive to market movements. Historically, these funds are known to give stable returns, even market slumps.

Ways to diversify your mutual funds portfolio:

How can you diversify your mutual fund investments?

Focus on asset allocation:

Asset allocation will depend on a lot of factors, the primary one being your risk appetite. Generally, the stage of life you’re in determines your capacity to tolerate losses. The other is your personal financial goals or investment milestones.

Let us say you are building a corpus for retirement through mutual funds. You have an asset allocation of 80% in equity and 20% in debt. There are two ways to manage asset allocation; one is strategic; the other is tactical.

It helps to review your portfolio every six months to see if the allocation needs to be switched out. In strategic asset allocation, going by the above example, we assume that your equity portfolio has grown to 90%. If you sell the appreciated portion and buy schemes associated with the other asset class, you bring the asset composition back to 80:20.

Aggressive investors may opt for tactical asset allocation. Here the portfolio is actively managed. The objective is to take advantage of market situations and generate better returns. Instead of investing separately in each type of fund, you can invest in hybrid or balanced funds that give you the best of both asset classes.

Diversify across market caps:

Diversify your investments in equity across different market caps. Investments in large-cap funds carry lower risk and tend to generate relatively stable returns. However, they may not give high returns in a bull market. Mid-cap and small-cap funds are comparatively riskier and may remain sensitive in a volatile market. However, they may also give exponential returns in a bull market.

Your portfolio should be divided across all these. The proportion of investments in each category will depend on your risk appetite. A small portion in small and mid-caps will help boost your portfolio returns. But a portfolio with a high concentration of these funds would be very risky. You may also choose to invest in a multi-cap fund. This will let you take advantage of opportunities in different market scenarios.

Even within debt funds, you could consider investments with varying maturities and types of credit risk.

Buy funds from different fund houses:

Each fund house has a distinct investment strategy to generate positive returns for the investor. At times, this strategy might not give the desired results. So, it is essential to spread your investment across fund houses. Also, different fund managers have different investment styles. Choosing funds from different fund houses may thus reduce your portfolio’s risk.

Don’t over-diversify:

Sometimes investors end up buying too many funds. They mistakenly think that more funds mean more diversification. But over-diversification does not necessarily reduce risk. Remember that investing in a mutual fund comes with costs. Also managing too many mutual funds is difficult. Invest in as many mutual funds as you can manage easily. Also, if you invest in too many similar funds it might mean you end investing in the same stocks. This defeats the purpose of diversification.

For example, let us say you are investing Rs. 25,000 every month. You are investing in an equity to debt ratio of 60:40. You may invest Rs. 5,000 each in three equity funds. The remaining Rs. 10,000 you may invest in 2 debt funds. The amount of diversification would also depend on the size of your portfolio. Say you are investing Rs. 10,000 every month. Then you should diversify your investments across a maximum of two or three funds.

Diversifying your portfolio based on an asset allocation strategy is important. It can go a long way in helping you achieve your investment goals.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing.