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mutual funds

Finance

ASSET ALLOCATION AND DIVERSIFICATION – ARE THEY RELATED?

You might have across the investment terms diversification and asset allocation quite often. These are essential concepts used while constructing a financial plan. However, often investors end up using these investment terms interchangeably. Though both these investment concepts aid in managing portfolio risk, are these two terms related? If yes, how exactly? Let’s explore that in this article.

What is asset allocation?

It is an investment strategy that allows investors to balance risk vs rewards by determining the right percentage of each asset class in a financial portfolio. This determination is basis the investment horizon, financial goals under consideration, and the income flows of the investor.

Traditionally, there are three main asset classes in the investing world – equities, debt, and cash and cash equivalents. One can also add precious metals (such as silver, platinum, gold, etc.) or real estate, and alternatives such as other collectables, coins, and art to this asset class mix.

Note that, the portfolio risk adopted is not done on some random whims, but a consequence of an investor’s wealth status.

So if you are an individual with a low risk appetite, or if you are nearing your retirement, your asset allocation strategy would be different than someone who is in their 20s or 30s or someone who has a high risk profile.

Why must an investor invest in different asset classes?

The basic principle behind investing in different asset classes is that when you invest in an array of asset classes that aren’t highly correlated, an investor can successfully reduce the volatility of an investment portfolio. What’s interesting to note here is that it is compulsory for the asset classes to be negatively corelated.

Note that, histrocially, bonds and equities do not move in same direction and the correlation between both these asset classes are low.

Diversification

Is your portfolio risk fully accounted for with just mere asset allocation strategy? What if an investor invests all their particular asset class such as debt or equity into a single fund or stock? Imagine Raj has a single stock in their portfolio while Ramesh has 10 stocks in his investment portfolio. So in case of Raj, if the company that he has invested in suffers business loss due to any reason, his investment portfolio could take a huge beating. On the other hand, in Ramesh’s case, if any one of the companies that he has invested in suffers business loss, it would not impact his investment portfolio to a huge extent as he is heavily diversified across various stocks. One stock going bad would only impact 1/10th of this investment portfolio.

However, note that though diversifying your portfolio can be quite beneficial to your portfolio, over diversification might turn the tables around and might not be as effective. Experts believe that if an investor diversifies their portfolio beyond 20 or 30 stocks, it would be counter-effective and not make much sense. You can choose to diversify your investments across asset classes (debt, equity, cash and cash equivalents), location (international funds, national funds, regional funds, etc.) and also sector funds. Next time you choose to invest in mutual funds, keep these points in mind. Happy investing!

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Investment

DEBT MUTUAL FUNDS VS FIXED DEPOSITS- WHAT MAKES FOR A BETTER CHOICE?

Though Fixed deposits (FDs) are considered as traditional investment options, they still find a place in most Indian households. As per the reports of Reserve Bank of India (RBI) released on June 2020, around 53% of average Indian household’s financial assets are dedicated towards fixed deposits as on March 2020. Though mutual funds are also seemingly popular among retail investors, these investment options raise to popularity in the recent decades. As per the date released by AMFI (Association of Mutual Funds in India), the AUM (asset under management) of mutual funds in India have grown at CAGR (compounded annual growth returns) of around 17% in the last twenty years. So, which of the above two investment options make for a better choice? Let’s understand and explore in this article.

What is a mutual fund?

Mutual funds are financial vehicles that are professionally managed by mutual fund experts known as fund managers. A fund house or an AMC (asset management company) pools the funds of several investors and invest in different securities basis the investment objective of the fund. Examples of such securities include cash and cash equivalents, stocks, money market instruments, bonds, etc. These fund managers have in-depth knowledge and understanding of the markets. You can invest in mutual funds either via a systematic and regular mode of investment – SIP (systematic investment plan) or lumpsum mode of investment.

What is a fixed deposit?

Fixed deposits are financial instruments provided by financial intermediaries such as NBFCs (Non-Banking Financial Company) or banks that offers investors with a fixed rate of interests for a fixed duration. The government of India predetermines this interest rate every year. Hence, these are relatively safer investment options than mutual fund investments. In return, investors are not allowed to redeem the schemes before the maturity of the term. Unlike mutual fund investments, you cannot make an SIP investment in fixed deposits. You need to make a lumpsum investment to invest in fixed deposit schemes.

Mutual funds vs fixed deposit

Let’s understand the differences between fixed deposits and mutual funds by referring to the following table:

Parameter Fixed deposits Mutual funds
Interest rates Fixed Vary as they are market-linked
Investment objective To preserve wealth To generate wealth
Market conditions Returns are not dependent on market conditions Market conditions play a significant role to calculate mutual funds returns
Risk Relatively lower risk as returns are predetermined and fixed Relatively higher risk
Expenses FDs do not levy any additional costs to investors Mutual funds levy certain charges and fees
Tax Dependent of the investor’s income tax slab Tax on mutual funds are dependent on the type of mutual funds invested in and the holding period of the investment
Lock-in period 5 years Except ELSS funds that have a lock-in period of 3 years, mutual funds do not have lock-in period
Mode of investment Only lumpsum investment Either SIP (systematic investment plan) or lumpsum investment

Where should I invest?

The decision to invest in mutual funds or fixed deposit lies with an investor. You must check your financial objectives, investment duration, and risk profile before deciding the right investment option for you. That being said, if you’re looking to generate wealth, you are better off with mutual funds as they have the potential to generate significant returns when invested for a prolonged duration. Happy investing!

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