The importance of diversification in ELSS fund investing

You may have come across Equity Linked Saving Schemes (ELSS) funds as an investor looking to save on taxes and grow wealth. ELSS funds are a popular investment option in India, as they offer tax benefits under Section 80C of the Income Tax Act while providing the potential for higher returns compared to traditional tax-saving instruments. 

However, like any investment, ELSS funds also carry risks. Diversification is a key strategy that can help mitigate those risks and optimise your investment returns.

What is diversification?

Diversification is spreading your investments across various asset classes, sectors, and companies to reduce risk. The idea behind diversification is that if one investment performs poorly, the losses will be offset by the gains in other investments. By diversifying your portfolio, you can reduce the overall risk of your investments while potentially earning higher returns.

Why is diversification important in ELSS fund investing?

While ELSS funds offer great tax benefits and potentially high returns, investing all your money in a single ELSS fund can be risky. ELSS funds primarily invest in equities subject to market volatility and can lead to losses. 

By diversifying your investments across multiple ELSS funds, you can spread your risk and potentially earn higher returns.

  • Mitigating concentration risk

ELSS funds primarily invest in equities, which are known to be more volatile compared to other asset classes. By diversifying your investments across a wide range of stocks, sectors, and market caps, you reduce the risk of your mutual fund portfolio being heavily concentrated in a few stocks or sectors. This way, if a particular stock or sector underperforms, the impact on your overall portfolio is minimised, as the gains from others can offset the losses from one investment.

  • Managing market fluctuations

Various factors, including economic conditions, global events, and market sentiments, influence equity markets. These factors can result in market fluctuations, and the performance of individual stocks or sectors may vary. 

Diversification helps you manage these fluctuations by spreading your investments across different stocks, sectors, and market caps. This way, even if a particular stock or sector performs poorly, the overall impact on your portfolio is reduced, as the gains from other investments can offset the losses.

  • Enhancing long-term returns

Investing in ELSS funds is a long-term commitment, with a mandatory lock-in period of three years. Diversification can help enhance your chances of earning attractive returns over the long term. Investing in a diversified portfolio of stocks, sectors, and market caps can capture the potential upside of different investment opportunities. This way, if some investments perform well, your portfolio’s overall returns may be higher compared to relying on a few concentrated investments.

  • Reducing portfolio risk

Diversification helps you reduce the overall risk of your portfolio. When you diversify your investments, you are not relying solely on the performance of a single stock or sector. This spreads the risk across different investments, reducing the impact of any single investment on your portfolio. This way, even if a particular stock or sector underperforms, the overall effect on your portfolio is minimised, and your investments are somewhat protected.

To wrap up

Investing in ELSS funds can be a great way to save taxes and grow your wealth. However, it is essential to diversify your investments across sectors, market capitalisations, and fund houses to minimise risk and earn higher returns.