What are the benefits of diversifying your mutual fund portfolio?
Have you ever set multiple alarms to wake you up? For example – Setting up alarms at 5:50 AM, 5:55 AM, 6:00 AM, 6:05 AM and 6:10 AM just so that you up at 6:00 AM.
This is typical of situations where you try to minimize risk of something unwanted happening – in this case, the unwanted situation is not waking up at 6:00 AM.
It doesn’t matter which alarm is largely responsible in waking you up, what matters is that you wake up! The alarm that is responsible for waking you up bears the burden of its work as well as the work of the other 4 alarms!
Similarly, in the investment world, it is recommended that you have a diversified portfolio – or many alarms!
Now, as mentioned here, you should only choose those investment assets that you understand – not just what makes the asset appreciate/depreciate in value but also what is the expected/historical risk, return and volatility over different periods of investment.
Further, the most important rule of diversification needs to be observed.
The assets in your portfolio should have a low correlation – don’t get bogged down by this simple term.
Correlation refers to the relative movement between two assets. When one asset goes up, what happens with the other asset is represented by the correlation of the two assets.
You can read more about correlation here.
For example – Equity and Debt, historically, have a low correlation. If equity is falling in value, debt will contain the fall and vice versa. But Equity mutual funds and direct equity have a high correlation – they will fall together thereby taking your entire portfolio down!