Diversification – The best way to overcome market volatility

When Romal completed his B. Tech from IIT Kanpur, in Computer Science, he received a stellar job offer as an AI developer with a startup and began earning more money than he had ever dreamt of – and he spent a year purchasing every luxurious item he could think of. However, at the end of his first year as an employee, he had an epiphany – he did not want to spend all his life working for the money he was earning. Rather, he wanted to build his own startup and remain at the forefront of technology, his first love and to make his dream come true, he needed a seed fund. From his conversations with a friend in finance, Romal realised that the best way to fuel his dream would be to utilise his earnings better and that is when he decided to work on his mutual fund portfolio along with his career. As an investor, he had another epiphany - in the ever-fluctuating landscape of financial markets, volatility was a constant companion.

For Romal and other investors, this volatility is both a source of anxiety and opportunity for while sudden market swings can trigger panic and rash decisions, they also present chances for savvy investors to capitalise on undervalued assets. In this tumultuous environment, one strategy stands out as a beacon of stability: mutual fund diversification. Romal began researching on how to diversify portfolio and this helped him gain better control of his mutual fund investment. By spreading investments across different mutual fund types, Romal began building a diversified mutual fund portfolio which would help him leverage volatility and attain his goal at the same time.

Importance of diversification

Every mutual fund portfolio requires optimal diversification to combat volatility – at its core, diversification is the practice of spreading investments across a range of assets to reduce exposure to any single risk. The fundamental premise of diversified mutual funds is simple: don't put all your eggs in one basket. By diversifying, investors aim to achieve a balance between risk and return, minimising the impact of adverse events on their overall portfolio. This strategy is based on the principle that different assets perform differently under varying market conditions. While some assets may decline in value, others may rise or remain stable, thus offsetting losses and smoothing out returns over time.

Correlation between asset classes

Central to the concept of diversification is correlation, which measures the degree to which the price movements of two assets are related. Assets with a correlation coefficient of +1 move in perfect tandem, while those with a correlation of -1 move in opposite directions and ideally, investors like Romal seek assets with low or negative correlations to achieve maximum diversification benefits. For instance, pairing investments in equity mutual fund with those in fixed income funds, which typically have an inverse relationship, can help stabilise a portfolio during market downturns.

Applying correlation to diversification

Understanding correlation is essential for effective diversification. By selecting assets with low or negative correlations, investors can create a portfolio that is resilient to market volatility. For example, during periods of economic uncertainty, stocks may experience significant declines, while government bonds may see increased demand as investors flock to safe-haven assets. By holding both stocks and bonds, investors can offset losses in one asset class with gains in the other, resulting in a smoother overall portfolio performance.

Tips to build a diversified mutual fund portfolio

• Avoid lump sum investments: During periods of heightened volatility, it is wise to avoid investing a large sum of money all at once. Instead, consider rupee-cost averaging, which involves spreading your investments over time. By investing fixed amounts at regular intervals, you can reduce the risk of buying at the market peak and benefit from purchasing assets at lower prices during downturns.

• Opt for the mutual fund SIP route: Mutual funds offer an excellent opportunity for diversification, as they pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets. Through systematic investment plans (SIPs), investors can automate regular contributions to mutual funds, taking advantage of rupee-cost averaging and mitigating the impact of market volatility on their investments.

• Keep a long-term horizon for equities: While equities are more volatile in the short term, they tend to deliver superior returns over the long term. By adopting a long-term investment horizon, investors can ride out market fluctuations and benefit from the compounding effect of reinvested dividends. Additionally, investing in a diversified portfolio of high-quality stocks can help spread risk and enhance overall portfolio resilience.

• Diversify across investing ecosystems: Diversification goes beyond asset allocation. Consider diversifying across geographical regions, industries, and investment strategies to further reduce risk. Investing in international markets can provide exposure to different economic cycles and currencies, while allocating to sectors with low correlation to each other can enhance diversification benefits.

• Practice diversification in debt: In addition to equities, debt instruments such as bonds and fixed-income securities can play a crucial role in diversifying a mutual fund portfolio. Government bonds, corporate bonds, and short-term instruments offer varying levels of risk and return potential, allowing investors to tailor their fixed-income allocation to their risk tolerance and investment objectives.

In an unpredictable market environment, diversification emerges as a reliable shield against volatility. By spreading investments across a range of assets, investors like Romal can minimise risk and smooth out mutual fund portfolio returns over time. Remember, while volatility may be inevitable, its impact on your investments can be mitigated through prudent diversification practices.

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