Investments and risk are inextricably intertwined. When an investor makes an investment, she is seen to be risking her money — either in part or full. However, losing money is never a goal, or even an intent, of investment.
Fund managers — therefore — make conscious efforts to pull the level of risk lower by resorting to what is known as ‘diversification’.
There are numerous risks of investing in stocks. These include price risk, market risk and even the company-specific risk.
What is diversification?
Diversification is one of the key advantages of investing in mutual funds. By the very definition of mutual funds, fund managers invest the assets of a scheme across a number of securities and debt instruments.
The process of making an investment across a number of financial instruments to lower the level of risk is referred to as diversification.
Mutual fund houses ensure that when the prices of one or more securities decline, the possible loss can be compensated by the possible increase in price of other securities wherein the fund is invested.
There is another form of risk known as liquidity risk. Thanks to regulations, mutual fund houses have to ensure that the proceeds of mutual funds are transferred to the bank account of the seller within two days of transaction (T+2).
Some of the equity mutual fund schemes are diversified by definition. For instance, Nifty index fund makes investment in 50 different stocks and Sensex 100 index fund diversified investment across top 100 stocks.
Similarly, flexi cap mutual funds invest their assets in securities across the market capitalisation spectrum (small cap, mid cap and large cap), thus following the doctrine of diversification in letter and spirit.
Finding out how diversified a mutual fund investment is pretty simple. One only needs to visit the web page of that specific scheme on the AMC's official website.
For instance, if you are curious to know the diversification done by ABSL Equity Savings Fund, you should visit the web page dedicated to this specific scheme on the official portal of Aditya Birla Sun Life AMC Ltd.
On this page, you should visit the section 'portfolio' to examine the number of securities which the mutual fund has invested into, and also the allocation to each of these stocks. This will give you a fair idea of the diversification resorted to by the mutual fund scheme.
Thematic mutual funds
Even the mutual funds that follow a particular theme such as value, contra and dividend yield also invest in a number of securities that align with these predefined themes.
Besides, these funds are mandated to invest a minimum of 65 percent of their assets in equity & equity related instruments.
They have a discretion to decide with the remaining 35 percent of their portfolio – which could again be invested across a number of asset classes such as bonds and gold.
So, overall, the mutual fund scheme becomes truly diversified in terms of its risk exposure.
There are a few mutual fund categories, however, that are highly concentrated in nature. For instance,sectoral funds that are meant to invest a majority of their assets in one particular industrial sector such as IT or FMCG.
These funds are naturally prone to a higher risk. These funds also adhere to some degree of diversification as they invest their funds across a number of companies -- albeit falling within the same sector.