How to achieve the right diversification in Mutual Funds?

The Efficient Market Hypothesis (EMH), proposed by Eugene Fama, argues that stocks always trade at fair value, making it extremely difficult for investors to consistently outperform the market. According to this view, earning returns above the benchmark is largely a matter of luck, which is why passive index investing gained widespread acceptance.

However, decades of research and market behaviour have revealed that certain investment processes or “factors” have historically generated excess returns over long periods. These sources of alpha often emerge because of behavioural biases, institutional constraints, or structural inefficiencies within markets.

Interestingly, even Fama later acknowledged the existence of such factors through his multi-factor models.

Factor investing attempts to systematically capture these long-term sources of outperformance. Let us understand the most important investing factors and why they tend to work over full market cycles.

1. Value Investing

What is Value Investing?

Value investing focuses on buying stocks that trade below their intrinsic or fair value.

Often, markets become excessively pessimistic about companies facing temporary challenges. Investors tend to focus heavily on short-term earnings pressure, negative sentiment, or cyclical downturns, causing stock prices to fall significantly below business value.

Value investors attempt to benefit from this gap between price and intrinsic worth.

Historically, portfolios built around undervalued businesses have generated superior long-term returns compared to the broader market.

Why Value Investing Works

Value investing is psychologically difficult because it requires investors to act against prevailing market sentiment.

These strategies often underperform during sharply rising markets where momentum-driven narratives dominate investor attention. However, value investing tends to protect downside better during difficult market phases and performs strongly over complete cycles.

Its effectiveness comes partly from behavioural inefficiencies — investors consistently overreact to short-term negative developments while underestimating long-term business recovery potential.

2. Momentum Investing

What is Momentum Investing?

Momentum investing focuses on buying stocks that are already demonstrating strong price trends.

Certain companies experience sustained positive momentum due to factors such as strong earnings growth, favorable industry cycles, policy tailwinds, product success, or improving investor sentiment. Momentum strategies attempt to capture these trends before they fully reverse.

By systematically rotating toward stronger-performing stocks, momentum investing seeks to generate returns above the market over time.

Why Momentum Investing Works

Momentum investing works largely because investors tend to underreact initially and overreact later to positive news.

As more market participants begin recognizing improving business conditions, buying activity accelerates and strengthens the existing trend.

Momentum strategies can be volatile and may underperform sharply during market reversals. However, across full bull-bear cycles, momentum has historically remained one of the strongest market factors.

Importantly, momentum and value investing often complement each other because they tend to outperform during different market environments.

3. Quality Investing

What is Quality Investing?

Quality investing focuses on businesses with durable competitive advantages, strong balance sheets, high profitability, and disciplined management.

Competitive advantages may emerge from brands, distribution strength, patents, regulation, low-cost operations, or superior execution capabilities.

Over long periods, quality businesses often compound earnings more consistently while managing downturns better than weaker businesses.

Why Quality Investing Works

Quality businesses often appear optically expensive in the short term, causing many investors to avoid them while chasing higher-risk opportunities with seemingly greater upside.

However, businesses with strong economics and sustainable competitive advantages frequently continue compounding value for far longer than markets initially expect.

As a result, companies that appear expensive on near-term metrics may still remain undervalued from a long-term perspective.

Quality investing therefore benefits from investors’ tendency to underestimate the durability of superior businesses.

4. Size-Based Investing

What is Size-Based Investing?

Size investing focuses on companies with relatively smaller market capitalization.

Smaller businesses often remain under-researched, less institutionally owned, and more prone to temporary mispricing compared to large-cap companies.

Over long periods, these inefficiencies can create opportunities for superior returns.

Why Size-Based Investing Works

Large institutional investors typically deploy capital into larger companies because liquidity constraints limit their ability to invest meaningfully in smaller businesses.

As a result, smaller companies often receive lower analyst coverage and reduced institutional attention.

This lack of market efficiency increases the probability of mispricing, creating opportunities for patient long-term investors.

However, small-cap investing can also experience extended periods of volatility and underperformance, especially during market downturns.

Why Diversifying Across Factors Matters

While each factor has historically generated excess returns over long periods, predicting exactly when a particular strategy will outperform is extremely difficult.

Some factors perform better during bull markets, while others perform better during corrections or recovery phases.

This is why diversification across investing styles becomes important.

Combining value, momentum, quality, and size-based strategies allows investors to participate across different market environments rather than depending entirely on a single factor or recent past performance.

However, factor diversification alone does not reduce overall equity market volatility because all these strategies still remain linked to equities.

To manage portfolio risk effectively, investors must also diversify across non-correlated asset classes such as debt, fixed income, and gold through disciplined asset allocation.

To assess how much of your monthly saving you should allocate to debt/fixed income +gold we recommend you do your Financial Planning using the MoneyWorks4me Financial Planning Tool. This can be invested in FD/RD in the largest & safest banks like SBI, HDFC and ICICI or in safe Liquid Fund.