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The Importance of Diversification in Mutual Fund

The stock market is unpredictable. It carries high volatility and high risk. Mutual Fund investment is generally considered one of the best instruments because it is not very risky and does not have much low return like Fixed deposit. But it does not guarantee a fixed amount of return. It depends on the market condition. The Mutual Fund also carries some high-risk high-return funds. It has various types according to its risk tolerance. Investing in a single instrument is like carrying a glass with a single hand. That means when you invest money in a single asset or single stock it carries high risk, because if a company or sector falls due to any economic reason then you will lose all the invested money. That’s why diversification plays an important role in reducing risk and managing balance. In this blog, we will see the information about the meaning of diversification. How does it reduce risk, and what are the benefits of diversification?

• What is diversification?

Diversification refers to dividing the investment amount into different stocks, assets, funds, and countries. Through this method, investor balances their portfolio. It helps investors to overcome any sudden drawdown happening in a particular company or sector. Diversification also helps to capture the sentimental rally of the particular sectors. 

Let's see the example, the why diversification important is,

You invested money into the single IT sector. You will get good returns no doubt but they carry high risk. Because IT sector is a cyclical sector that has a direct correlation with the economic slowdown, inflation and other geopolitical events.

And opposite to this you diversified your portfolio into a cyclical sector. Like the pharma and FMCG sector or defensive sector which help to balance the portfolio. The defensive sector performs well in the economic slowdown because of its increasing demand.

• How does diversification reduce the risk?

•  Protection against the downfall of stock or sector:

Different sectors or stocks perform differently according to any economic changes. In this scenario, diversification helps to reduce the risk.

1.  Protection against volatility :

Volatility may lead to sudden rise and fall in the market. If the equity market falls then gold and bond prices may rise. Diversification helps to maintain risk levels.

1.  Geopolitical Risk:

Investing in global equity prevents from downfall of any single country or does not miss the extraordinary growth rate of any country.

1.  Provide consistent Returns:

In a diversified portfolio,  there is a low possibility of the portfolio in which all the assets can generate a negative return.  Most of the time it gives consistent returns.

• Type of diversification in Mutual Funds:

1.  Asset Diversification:

In India, we can invest across different assets like Equity Funds, Debt Funds, Hybrid Funds, Gold Funds etc. It helps to reduce the impact of volatility. Let's see the examples of  30% equity fund, 60% debt fund, and 10% other fund show the balance in asset allocation.

1.  Diversification based on market cap:

Large-cap, mid-cap, and small-cap are the types of equity funds. Large caps are the high risk, and small caps are the low risk. Generally, the Flexi cap fund is invested in all three caps.

1.  Sector diversification:

Diversifying investment into the cyclical sector and defensive sector. If you invested 30% In the IT sector, 40% in the Pharma sector and 30% in Real Estate, which helps to balance your investment.

1.  Diversification based on the types of the fund :

Value Funds are invested into the company which has strong fundamentals and future growth potential. Growth Fund invested in tech companies or fintech startups.  Blend fund or mixed fund investments depend on growth and value fund strategies.

1.  Geographical Diversification :

Country-wise diversification of investment helps to avoid risks associated with any single country. 

• Conclusion:

Diversification is one of the crucial principles of investing by diversifying a portfolio into various assets we can balance the risk. It helps to overcome the challenge of volatility. Also, it helps to minimize the risk and increase the potential return. In conclusion, diversification in mutual funds is essential for managing risk, achieving stable returns, and building long-term wealth. It provides investors with a disciplined approach to investing, balancing potential rewards with the need for security. As part of a well-rounded financial plan, diversified Mutual Funds remain a reliable tool for achieving financial goals.

• FAQ:

• Why is diversification important in Mutual Funds?

Ans: Diversification helps to reduce risk on any single asset. It balances the whole portfolio in high volatility.

1. What is the motive for diversification?

Ans: The main motive for the diversification is to reduce the risk and increase the profit potential.

1. What is the principle of diversification?

Ans: Diversifying the investment into a different asset which help to mitigate the risk, and get consistent returns. 

1. What is the benefit of purchasing a Mutual Fund?

Ans: Through a Mutual Fund we can access most investment options like stocks, bonds, commodities and various other instruments. 

1. What is the rule of diversification? 

Ans: The rule of diversification depends on the risk-taking capacity of every investor . but one universal rule is for diversifying the investment which is don’t put all the eggs in one basket.