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Importance of diversification in ELSS investments

Equity linked savings scheme (ELSS) funds are tax saving mutual funds that offer investors a unique opportunity for capital appreciation and building wealth – all while saving taxes. Yet, investing in just one ELSS fund may not be enough to maximise your potential returns. An ELSS investment carries higher risks than other forms of investment due to its high exposure to the equity and equity-linked securities. To mitigate this risk, diversification is a key element.

Read on to understand why diversifying your ELSS portfolio should be at the core of your financial planning strategy regardless of your goals.

  • Helps in risk management

Diversifying your ELSS investments helps you limit your exposure to any single sector or industry.

For example, if you invest in just one sector, such as technology stocks, and it performs poorly, then your portfolio will suffer greatly. However, if you have invested in multiple sectors, such as health care, manufacturing, and financial services, then even if one sector underperforms, the other sectors may be able to offset the losses and keep your portfolio afloat.

  • Offers benefit of different market capitalisation

The risk profile of ELSS funds differs significantly from scheme to scheme as they invest across different market capitalisations (large caps, mid caps, small caps).

Large-cap stocks are typically more stable and provide slower but steady growth potential. Mid-cap stocks offer more growth potential than large-cap ones but are also more volatile. Small-cap stocks are the most volatile but also offer the highest growth potential. By investing in ELSS funds focusing primarily on each capitalization (such as small-cap-focused ELSS fund), you can balance out your portfolio so that you are not too exposed to any one type of stock.

  • Diversification provides more opportunities for growth

Investing in more than one ELSS fund offers you more growth opportunities while still taking advantage of potentially higher returns. This is because each fund has the potential to perform differently from the others and may be affected differently by market movements. This helps to reduce the impact of short-term market fluctuations on your overall investments.

How to diversify your ELSS investment portfolio?

  • Consider both the asset allocation and sector weightings within each fund. Asset allocation refers to how much of your money is allocated toward different asset classes such as stocks, bonds, etc. The sector weighting then determines which specific industries make up the fund. By understanding these two components and adjusting them accordingly, you can create a more balanced mutual fund portfolio that takes into account short-term volatility and long-term inflation-beating returns on investments.
  • Different ELSS mutual funds follow different strategies for maintaining a portfolio. Some funds might concentrate on limited stocks, investing a greater portion of the total portfolio in each one. Others may opt for spreading the investment around a wider range of stocks, ensuring almost equal distribution among them. It is advisable to invest in ELSS funds that have a well-diversified portfolio.
  • To maximise returns on your ELSS investments, one of the best strategies you can use is diversifying your portfolio. An easy and cost-effective way to do this is by setting up a systematic investment plan (SIP). With an SIP, you invest a fixed amount at regular intervals and reap the benefits that rupee cost averaging has to offer over time. You can start small – with a low initial commitment and take advantage of market fluctuations.

ELSS, along with any other investments, requires strategic planning and a thorough understanding of the market. Therefore, before investing, it is crucial to evaluate market conditions, your risk tolerance levels, strategies, financial goals, and, most importantly, portfolio diversification plans.

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