How to build a diversified mutual fund portfolio

Published: April 30, 2016 at 7:52 am

Last Updated on August 30, 2021 at 3:33 pm

Diversification refers to the simple common sense, ‘not to rely too much on one entity’. In this post, I discuss simple ways to build a diversified portfolio using mutual funds.

The main purpose of diversification is to minimise losses, or rather the volatility in the portfolio value. This implies reducing exposure to an asset class with ‘potential’ to offer high returns.

Step 1: Decide on the investment strategy. Are you going to invest systematically, time the market etc. I dont know which is better and I dont care. All I know is that we need to do what is suitable for our temperament.

Step 2: Decide on the percentage exposure to equity, fixed income and any other asset class that you are comfortable with. This is referred to as asset allocation. There many asset allocation strategies. I shall cover these in another post. For now, let consider a simple plan: 60% equity, 40% fixed income. This automatically means that we are planning for a long-term goal: Equity investing: How to define ‘long-term’ and ‘short-term’

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥

Step 3: Recognise that the percentage allocations mentioned above will change on a daily basis due to fluctuations in market value. We need to rest the allocation back in line with our plan from time to time. This is referred to as rebalancing. I had written about this earlier, but will revisit this area in another post.

Step 4:  Diversification refers to two distinct processes (a) diversification across asset classes – equity, fixed income, gold (if comfortable) etc. and (b) diversification within an asset class. It is this part that we shall focus on in this post.

Step 5: Decide on fixed income strategy. Some investors (me too) prefer rock-solid fixed income and prefer to have volatility in equity alone. So for long-term goals, the natural choices of fixed income instruments are EPF, VPF, PPF – tax-free fixed income.

For goals where such instruments are not suitable, debt mutual funds can be an option. Here again, I would recommend not to diversify across debt fund categories and low volatile ones like liquid funds, ultra short-term funds or (ultra) short-term gilt funds: How to choose debt mutual funds with no credit risk and low volatility. Some people refer to have some tactical exposure to long-term gilt funds.

Step 6: Building a diversified equity portfolio. This can be with 100% direct stocks, 100% mutual funds or a mix of the two.

It is probably easier to build a diversified direct equity portfolio by picking stocks across sectors. When it comes to mutual funds, most portfolios (including mine) are a mess because we buy funds without thinking too much about diversification and the importance of a minimalist Portfolio. Cluttered portfolios can be rectified gradually with a clear plan.

I would like to give you an explicit example of building a minimalist equity portfolio. The minimum number of funds necessary to do this is just one (at least for young earners)!

As long as you need the 80C tax break, a single ELSS fund will give you the necessary diversification. No other equity fund is necessary.

Or you can use your expenses + EPF+ PPF for 80C and not use ELSS funds. This is probably a better strategy.

A simple investment strategy is one-large cap fund + one mid/small- cap fund. Just two funds.

One can also consider just a single multi-cap fund or a single balanced fund and treat it as pure equity.

Examples of the two-fund strategy.

(a) Hunt for a pure large cap fund or any fund that has a strategy to stick to the top 50 or 100 stocks by market capitalization. This typically means funds which can pick from the BSE 100 index.  Almost every AMC has a fund which fits the bill and they are often named ‘top 100’.

Examples: Frankin Blue Chip, DSP Top 100, Birla top 100 etc.

(b) Hunt for a non-large cap fund. That is funds which will not invest in the top 100 stocks by market capitalization. For example. Mirae Asset Emerging Blue Chip has such a mandate. Other funds which generally do not hold large cap stocks, Franklin Prima, IDFC premier equity, UTI mid-cap etc. It is easy enough to find out in the Value Research Mid-cap category listing.

There is no evidence that AUM impacts fund performance. However, size of the fund matters for style purity. Large the AUM, more would the large cap exposure. So smaller funds which no one is talking about would be better.

Investors exhibit a lot of herd instincts. So it is quite easy to spot quiet but consistent performers.

That is it! You now have two funds which can give you the diversification across market caps.

Diversification across sectors. This is a bit trickier can change a lot depending on market conditions.Most portfolios tend to be overweight on the financial sector.

If this is important to you then, shortlist a few funds based on market cap. Create an account with a portfolio manager like Value Research and enter some dummy transactions with those funds. The analysis tab will give you detailed insights.

For example, this is  a dummy portfolio with 50% investment in PPFAS and 50% in Franklin Blue Chip.

portfolio-diversification-2 portfolio-diversification-1

Such a two fund portfolio is reasonably diversified across both market cap and sectors (a bit too much on financials -a common problem). Without too much analysis, I would settle for such portfolio.

Step 7: The last step is to decide allocation to large cap and the mid/small cap fund. I would recommend 60%-70% large cap for new investors. After a few years, they can decrease large cap exposure. but I would suggest not going below 50%.

This is the first in a series of simple portfolio management steps. If you have any post suggestions, I am all ears.

Do share this article with your friends using the buttons below.

🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
Follow Freefincal on Google News
Follow Freefincal on Google News
Subscribe to the freefincal Youtube Channel. Subscribe button courtesy: Vecteezy.
Subscribe to the freefincal Youtube Channel.
Follow freefincal on WhatsApp Channel
Follow freefincal on WhatsApp
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! 
Listen to the Lets Get Rich with Pattu Podcast
Listen to the Let's Get Rich with Pattu Podcast
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
Lets Get RICH With PATTU podcast on YouTube
Let's Get RICH With PATTU podcast on YouTube.
🔥Now Watch Let's Get Rich With Pattu தமிழில் (in Tamil)! 🔥
  • Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
  • Have a question? Subscribe to our newsletter using the form below.
  • Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!

About The Author

Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course!  Increase your income by getting people to pay for your skills! More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!   
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both the boy and girl-version covers of "Chinchu Gets a superpower".
Most investor problems can be traced to a lack of informed decision-making. We made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So, in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it, as well as teaching him several key ideas of decision-making and money management, is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)