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Sunday, October 12, 2025

Diversification and Portfolio Management - Newspaper Summary

 The sources provide an extensive analysis of Diversification and Portfolio Management within the larger framework of Personal Finance and Investment Strategies, emphasizing the necessity of thoughtful asset allocation while warning against the pitfalls of mere fund proliferation.

The Role and Necessity of Diversification

Diversification is highlighted as a key ingredient for making money and is considered essential to hedge a portfolio against changing market cycles. Because different asset classes lead the returns charts every year (e.g., Equity, Gold, Silver, Real Estate, Debt all show varying annual returns), blending them is necessary.

The primary rationale for diversification is to reduce risk. By allocating to multiple uncorrelated asset classes, potential losses in struggling assets are likely to be tempered by those in a stronger position, thereby making portfolios more resilient in the long run.

Investment strategies must align diversification efforts with the investor's time horizon and risk profile:

  1. Long Term (7+ years): Equity dominates, as volatility smooths out over time, prioritizing wealth creation and compounding. Suggested asset allocation ranges from 50–100% Equity, 0–40% Debt, and up to 10% Gold.
  2. Medium Term (3–7 years): A balanced approach is suggested, with Debt acting as the anchor for stability. Recommended allocation is 10–60% Equity, 30–80% Debt, and 0–10% Gold.

The Pitfall of Over-Diversification and Duplication

While the instinct to diversify often comes from a place of caution, it frequently results in duplication. The sources strongly caution that over-diversification can erode returns and make a portfolio nearly impossible to track.

Key problems with over-diversification include:

  • Duplication of Holdings: Investors sometimes mistake "variety" (owning many funds) for genuine diversification. One investor who owned 18 funds realized they were essentially buying the same top companies (like Reliance Industries, ICICI Bank, Infosys) through different funds, resulting in duplication.
  • Eroded Returns: Owning too many funds can create index-like portfolios with vast overlaps. When a portfolio is spread across too many funds, diversification reduces the impact of a poor performer, but simultaneously minimizes the effect of every good one, preventing any single winner from making a meaningful difference.
  • Amplified Volatility: Owning multiple funds across the same category (e.g., mid-cap or thematic funds) might offer exposure to different stories on paper, but in reality, these funds often move in tandem, thereby amplifying volatility rather than reducing it.

To combat duplication, investors are advised to utilize fund overlap analysis; if two funds share over a 25% overlap in holdings, owning both seldom adds value.

Principles of Effective Portfolio Management

Effective portfolio management prioritizes fewer, well-chosen funds over a scattered collection.

  1. Optimal Fund Count: Financial planners typically suggest limiting the core equity portfolio to three to five funds. An example of a streamlined portfolio that provided better returns and was easy to track contained just six funds: two flexi caps, one mid cap, a hybrid, a gold exchange-traded fund (ETF), and a short-duration debt fund.
  2. Defining Fund Roles: Every fund in the portfolio must have a defined role. If two funds are serving the same purpose, one is unnecessary.
  3. Beyond Market Cap Diversification: True diversification should look beyond market capitalization labels (large-cap, mid-cap, flexi-cap) and include style diversification. If all funds follow a growth-oriented style, they will behave similarly across most market cycles. Investors should blend styles, specifically Growth and Value.
    • Value investing involves selecting solid, proven companies trading at reasonable prices.
    • Growth investing involves betting on companies with high future potential, relying heavily on the fund manager’s skill.
  4. Allocating Sufficient Capital: It is essential to allocate sufficient funds to each chosen investment; otherwise, even if a fund performs well, the investor will not see a meaningful return.

Diversification through Specific Asset Classes and Instruments

The sources detail several asset classes and professional vehicles used for diversification:

1. Multi-Asset and Hybrid Funds

Multi-asset allocation funds are a strategy to address diversification directly. These funds are explicitly designed to balance out volatility across asset classes (equity, debt, and global allocations). They provide a judicious mix of multiple asset classes in one basket, thereby sparing investors the tasks of identifying proper allocation and subsequent rebalancing.

Multi-asset funds have proved resilient, even during challenging periods when the equity market corrected sharply (posting gains while mainstream indices were in the red). They are suitable core building blocks for long-term portfolios, offering diversified exposure that helps smooth returns and reduce drawdowns. Furthermore, multi-asset funds can rebalance internally between assets without triggering tax for the investor, making them convenient and tax-efficient.

2. Real Estate (REITs and AIFs)

Diversification for wealth creation has shifted beyond traditional home ownership. Modern strategies increasingly involve Commercial Real Estate, REITs, and AIFs.

  • REITs (Real Estate Investment Trusts): These vehicles pool investor money into high-quality assets (offices, malls, warehouses). They offer transparency, scale, stability, and crucial liquidity (units can be bought and sold like stocks) that physical assets lack. They generate attractive rental yields, often in the 7–10% range.
  • AIFs (Alternative Investment Funds): AIFs blend income-generating assets with projects aimed at capital appreciation, targeting HNIs and UHNIs. They offer diversification across geographies and property types (e.g., warehouses in Pune, offices in Bengaluru), lowering concentration risk. Debt real estate AIFs target internal rates of return (IRRs) of 14–16%, and Equity real estate AIFs can generate IRRs above 20%.

A comprehensive approach to real estate diversification suggests a thoughtful mix of REITs, AIFs, and select residential holdings to balance stability, liquidity, and growth.

3. Precious Metals (Gold and Silver)

Gold is considered a proven hedge against market volatility, due to its low correlation with equities and inflation-hedging ability. Portfolios containing gold have demonstrated notable returns boosts and anchors stability.

Silver is also gaining favor, driven by its dual nature as both a safe haven and an industrial commodity (used in EVs, solar panels, and electronics). However, silver is more volatile than gold.

For investment, experts recommend paper gold (ETFs or mutual funds) over physical gold due to convenience, lack of storage/purity concerns, and efficiency. Total combined exposure to gold and silver should typically be limited to 10–12% of the overall portfolio, with silver specifically capped at 2–4%, viewed as a tactical opportunity suited to specific market phases.

4. Avoiding Unproven Products (NFOs)

A common behavior that undermines good investment strategy is constantly chasing New Fund Offers (NFOs). Experts classify the belief that a ₹10 NAV makes an NFO cheaper as "deeply flawed," as the performance depends solely on the underlying portfolio and manager skill, not the NAV price. Many NFOs, particularly sectoral or thematic ones, have been found to underperform their category average within six months. Investors are urged to stick to funds with proven track records and wait for evidence before investing in new launches.

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