Diversification aids in risk reduction, but it is ineffective if not executed correctly.

Diversification is a rather basic concept. Different asset classes perform differently in various market cycles. So also, every asset class has its upswing and downturns. The secret sauce to profitable fund investments is the right amount of diversification. Investing in too many funds with insufficient diversification makes your holdings unproductive and more vulnerable to market risks.

To the question, how many funds does an ideal portfolio have? Well, you are expecting a one size fits all answer. There is no precise number that answers your query. The true magic lies in your underlying assets and the beauty of its diversification in quality and not quantity.

While adding a fund to your portfolio, there are few things to keep in mind:

What is the correlation of that fund to the other assets in my portfolio? You do not want to add a fund that is similar to your existing investments. For instance, if you invest in a large-cap fund under the banking sector and invest in individual stocks for other banks, you are also opening your portfolio to sectoral risks. The concentration of highly correlated assets in a single portfolio is a big No-No.

Does that fund add value to my portfolio? Investments are planned with goals in mind. Any fund added should be attached and aligned to your long or short-term financial goals. Random investing without mapping goals or checking risk appetite is the first pitfall naive investors make.

A robust investment approach that we recommend following is the Core-Satellite approach. It is a balanced combination of passive investing and active management. The benefits of this strategy are:

  • Brings discipline in investing
  • Minimizes costs of fund management
  • Reduces Volatility
  • Optimum diversification
  • Tax efficient

How does this approach work?

Here, an investor’s portfolio is divided into two segments a Core and a Satellite.

The portfolio’s core part is in sturdy, long-term buy and hold investments that seek market returns while keeping costs and risks extremely low. The purpose of these funds is linked to long-term investment horizons and thus delivers long-term competitive performance and risk-adjusted returns. Long-term investments in a well-diversified portfolio ensures lesser exposure to market-related risks. Investments like diversified large cap, mid-to-large cap oriented strategy or even short-term debt funds work well for the core part of your portfolio.

The satellite part of your portfolio is in tactical investments. These investments seek to outperform the market. While the risks involved may be higher and costs of fund management may be higher too, they tend to offer higher liquidity on the upside. This part of your portfolio will align best with your short-term goals. Example of satellite funds could be sectoral funds, index funds, small cap funds, theme based funds, etc.

A core-satellite approach can offer investors a well-diversified portfolio and outperform benchmarks with most efficient risk-adjusted returns for investors.

What’s your investment strategy? Do you have one?