The importance of equity mutual fund diversification

It's best to have a compact mutual fund portfolio | Mint

Diversification is a key concept when it comes to making wise investments in the stock market, and this is especially true when investing in equity funds. Equity funds are mutual fund schemes that primarily invest in stocks/shares of companies across different market capitalisations.

There are different types of equity funds, including small-cap funds, mid-cap funds, large-cap funds, sector funds, thematic funds, and flexi-cap/multi-cap funds. These funds cover different market segments and follow unique strategies to fit the needs and goals of individual investors. Without proper diversification, you can overexpose yourself to a single security or sector, making your mutual fund portfolio more vulnerable to market fluctuations.

Here are some pointers that discuss the importance of diversification in equity fund investments in more detail.

  1. Diversification reduces risk

Different types mutual funds tend to perform differently in different market conditions. For example, small-cap stocks tend to be more volatile than large-cap stocks, but they also have the potential to generate higher returns over the long term.

By having a diversified portfolio of equity funds with varying capitalisations, you can balance the risk and potential reward of your portfolio. This further helps protect against volatility because if one fund performs poorly due to economic or market conditions, another may still perform well.

  1. Diversification helps maximise returns

Diversification can also help you maximise returns by giving you exposure to various investment opportunities.

For example, if you invest only in large cap equity mutual funds, you may miss out on the higher returns that small-cap stocks can provide in a bull market. And if you invest only in small-cap funds, you may be taking on too much risk for the potential rewards.

To ensure balanced exposure and a well-rounded portfolio, consider funds focusing on large- and small-caps along with sectoral/thematic funds that target specific sectors such as banking, service, information technology or pharma sector.

  1. Tax benefits

Another benefit of equity mutual fund diversification is that you can benefit from tax savings through certain investment products like ELSS or equity linked savings schemes. These schemes provide tax deductions under Section 80C of the Income Tax Act 1961, which can significantly reduce the amount of taxes you need to pay on your income.

Additionally, ELSS schemes also have a lock-in period of three years, which encourages investors to stay disciplined and make long-term investments without worrying about short-term market volatility.

  1. Diversification allows you to weather market volatility

Diversification can help you manage market volatility better than if you had invested all your money in one asset class. For example, if the stock market crashes and small cap mutual funds take a hit, the value of your large-cap holdings can offset some of the losses incurred by your small/mid-cap investments.

Similarly, if mid-cap stocks or sectoral/thematic funds underperform during a particular year, the performance of your other investments may mitigate the loss. This way, you can protect yourself from short-term market fluctuations and ride out longer-term trends more effectively.

Closing thoughts

Equity mutual funds can add a lot of value to your investment portfolio, but it’s important to remember that they are best viewed as long-term investments. They can be volatile in the short term, but over time, the market can have the chance to rebound and give you an opportunity to recover any short-term losses you may have incurred.

Besides diversification, make sure to invest in a long-term equity fund and have patience as an investor. Remember, patience is paramount when it comes to reaping the rewards of compounding!