Last Updated on Apr 21, 2025 by Harshit Singh
Portfolio diversification stands as one of the most fundamental principles in investment management. A well-diversified portfolio helps reduce the impact of market volatility in the long term.
How do we make one? Let’s dive deeper.
Table of Contents
Why Diversification Matters
Portfolio diversification simply means spreading your investments across various asset classes, industries (sectors), and geographic regions to minimise overall risk by avoiding overconcentration in a single investment.
For example, if you invest only in technology stocks and the sector crashes, your portfolio takes a big hit. But if you also hold investments in other sectors like healthcare, energy, and bonds etc, the losses in one area might be balanced by gains in another.
This concept of diversification is called the Modern Portfolio Theory (MPT), also known as the Markowitz Portfolio Theory or the Passive Investment Approach.
The said theory is developed by economist Harry Markowitz, that establishes:
1. An investor’s primary goal is to maximise returns for any given level of risk.
2. Risk may be effectively reduced through a diversified portfolio of uncorrelated assets.
The Role of Passive Funds in Diversification
“Someone’s sitting in the shade today because someone planted a tree a long time ago,” market veteran Warren Buffet said of his long-term investment ethos.
And speaking of long term, passive investing has gained traction over the years, especially with the increase in the launch of index funds, exchange-traded funds (ETFs) and, to some extent, fund of funds (FoFs), in which due to design viz., investing in single underlying may be considered as passive.
Unlike actively managed funds, which try to beat the market through stock picking and market timing, passive funds track the performance of a market index, such as Nifty or Sensex, rather than trying to outperform it.
This approach comes with certain advantages and disadvantages for investors looking to go the long haul:
| Advantages | Disadvantages |
| Lower Expense Ratio: Passive funds have a lower expense ratio as they follow a predetermined index rather than requiring active management. | No Market Outperformance: Passive funds aim to match the benchmark index, not beat it. |
| Broad Market Exposure: Passive Funds like index funds or ETFs provide diversification by holding a wide range of stocks or bonds within an index. | Less Flexibility: Fund managers cannot pick securities actively. |
| Transparency: Investors know precisely what they invest in, as passive funds track predefined indices. | Tracking Error: If a fund does not perfectly mirror its benchmark, it can lead to tracking errors, causing deviations in performance. |
All in all, the passive fund now encompasses various investment vehicles designed to meet different investor needs i.e.,
Index funds offer a mutual fund structure that tracks a specific market index and are priced at the end of the trading day, while ETFs provide similar index-tracking capabilities but trade on exchanges like individual stocks, offering intraday liquidity.
How to Diversify Using Passive Funds?
To diversify with passive funds, allocate your investments using passive investment vehicles like index funds and ETFs. This ensures exposure to various sectors and regions by spreading your investments across the market.
Here’s how you can do it:
1. Diversify Across Asset Classes
Portfolios can include a mix of asset types, which may influence how they respond to market movements. Common asset classes include:
- Equities: Stock index funds are often associated with long-term growth potential.
- Debts: The bond market is often referred to as the debt market, fixed-income market, or credit market. Bond index funds are generally considered for income generation and lower volatility.
- Tangible Assets: Real estate, like land, buildings, commercial or residential properties, and commodities like gold and silver, are sometimes used to offset inflationary pressures.
Note: The performance of all types of asset classes is subject to market movements. Please do your own research and consult your tax advisor before investing.
2. Diversify Within Asset Classes
Even within a single asset class, you can make variations based on sector, size, or structure:
- Equities: Exposure can span sectors such as technology, healthcare, and financials, along with different market capitalisations like large-cap, mid-cap, and small-cap funds.
- Debts: Portfolios may include a mix of government and corporate bonds, along with a range of maturities to navigate interest rate changes.
3. Build and Rebuild Your Portfolio
Invest consistently. If you have ₹50,000 to invest, consider rupee-cost averaging (RCA) to reduce market volatility. This strategy helps manage risk by spreading investments over time.
| FACT BOX: Rupee cost averaging (RCA) is an investment strategy where you invest a fixed amount of money into a mutual fund at regular intervals. This helps you buy more units when prices are low and fewer when prices are high. Over time, this averages out the cost of your investments. |
Maintaining Your Diversified Portfolio
A diversified portfolio can shift over time as some investments grow faster than others, so it may need occasional rebalancing to fit an investor’s risk tolerance and investment objectives. Here’s how to keep things in check:
- Regular Monitoring: Review your portfolio from time to time.
- Rebalancing: If one asset class becomes too dominant (e.g., equities rise to 80% from an initial 70%), rebalance by selling some and reallocating.
- Tax Efficiency: When rebalancing, consider tax implications. Pro tip: ETFs generally have lower tax liabilities than actively managed funds.
To Wrap Up
Passive investing strategies can be one of the several approaches investors may use for long-term wealth-building*. So, whether you’re starting out or revisiting your investment plan, passive funds can be a viable option to consider as part of a broader strategy.
*Past performance is not indicative of future results. Before making any investment decisions, investors should conduct their own research and seek advice from qualified financial advisors to ensure that the respective funds, products and strategies are suitable for their specific financial situation and objectives.
Disclaimers:
An Investor education and awareness initiative by Zerodha Mutual Fund.
Know Your Customer: To invest in the schemes of Mutual Fund (MF), an investor needs to be compliant with the KYC (Know Your Customer) norms and the procedure is -> Fill the Common KYC (CKYC) application form by referring to the instructions given below:
Enclose self-certified copies of both proof of identity and address. For Proof of Identity, submit any one document – PAN/ passport / voter ID/ driving license/ Aadhaar / NREGA job card/ any other document notified by central government. Proof of address, submit any one document which is the same as the proof of identity, except for PAN (since this document does not specify the address). If your permanent address is different from the correspondence address, then you need to submit proof for both the addresses. Documents Attestation – By any one from the authorized officials as mentioned under instructions printed on the CKYC application form. PAN Exempt Investor Category (PEKRN) – Refers to investments (including SIPs) in MF schemes up to INR 50,000/- per investor per year per Mutual Fund. This set of investors need to submit alternate proof of identity in lieu of PAN. In Person Verification (IPV) – This is a mandatory requirement and can be done by the list of officials mentioned in the instructions printed overleaf on the CKYC application form. Please submit the completed CKYC application form along with supporting documents at any of the point of acceptance like offices of the Mutual Fund/ Registrar, etc.
Investors may also complete their KYC online through Aadhar OTP-based authentication. Visit the respective fund house website or contact their customer care to know more about the process.
Modification to existing details like address/ contact details/ name etc. in KYC records – For any modifications to be done to the existing KYC details, the process remains same as mentioned above, except that only the details to be changed needs to be mentioned on the form along with PAN/ PEKRN and submitted with the relevant proofs.
Modification to your existing details like contact details/ name/ tax status/ bank details/nomination/ FATCA etc in Fund House records – Please visit the website of the respective Fund House to understand the procedure to update the details (if published) OR reach out to the customer service team of the respective Fund House.
Dealing with registered Mutual Funds
Investors are urged to deal with registered Mutual Funds only, details of which can be verified on the SEBI website (www.sebi.gov.in) under Intermediaries/ Market Infrastructure Institutions.
Redressal of Complaints
If you have any queries, grievances or complaints pertaining to your investments, you may approach the respective Fund House through various avenues published on their website. If you are not satisfied with the responses provided by the Fund House, you may then register your complaint on SCORES (Sebi Complaints Redress System) portal provided by SEBI for which the link is -> https://scores.sebi.gov.in
Other Disclaimer: The Content of this article/document is for educational and informational purposes only and should not be construed as financial advice. Please consult your financial advisor for advice suited to your specific circumstances.
Investing in mutual funds and other financial products involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, investors should conduct their own research and seek advice from qualified financial advisors to ensure that the respective products and strategies are suitable for their specific financial situation and objectives.
Tax benefits, if any, are subject to changes in tax laws. Investors are advised to consult their tax advisors before making any investment decisions.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
Active on Twitter, my favourite pastime entails (but is not limited to) discussing movies, fiction novels. A forever music enthusiast, I love to strum some chords on my guitar from time to time.
- How to Build a Diversified Portfolio Using Passive Funds - Apr 21, 2025
- Sachetisation of Mutual Fund Investments: SEBI’s Initiative for Small-ticket SIPs - Feb 27, 2025
- ETFs vs Index Funds: A Guide to Passive Investing - Feb 27, 2025
