When we talk about best investments, people are often drawn towards mutual funds. It is a must in every person’s portfolio. But one of the main questions after making an investment decision is how much is too much. Mutual funds have multiple variants based on many categories, hence, it is difficult to choose a suitable mutual fund that meets your requirements without having a fair idea about these products.
So let’s discuss this topic to help you decide what is the ideal count of mutual funds in your portfolio
Perils of over diversification
One of the main advantages of mutual funds is the diversification offered by the fund. A mutual fund investor can essentially own multiple securities in a single unit of the fund. This not only spreads the risk of investment but will also give the investor a chance to maximize their returns. But it is important to note that this benefit of diversification can become pointless or even harm your portfolio if it is overdone.
The first step of investment is research. It is essential to know about the mutual funds, the various types, investment mode, etc. to make sound investment decisions. This will help you know the right type of fund for you. Most investors tend to invest in all the 15-20 funds that have been shortlisted. This is not the correct approach and can be in the lines of over diversification. Such over-diversification may effectively result in lower returns as the company having better results would account for a lower percentage of the portfolio.
Investment across different fund types/categories
As mentioned above, there are many types or categories of mutual funds. The most basic classification is equity funds, debt funds or hybrid funds (combination of equity and debt).
Investment decision is heavily based on these types factoring in the risk associated with each type of fund. Once a decision is made in this regard, the next step is to select among the various funds available under each category like large cap, mid cap, small cap funds, gilt funds, corporate funds, tax saving funds, etc.
Some of the crucial errors while selecting the funds made by many investors is investing in every fund category or buying too many funds of the same profile. When investment is to be made considering the risk and return correlation, investing in practically every fund category makes no sense as not every category meets this correlation or the investment objective. Also, when investment is made in too many funds of the same category there is no fundamental addition to the portfolio.
For example, if you invest in many large-cap funds, the different options in this category will have an investment in more or less the same equity stocks with tiny variations in the weightage of such equity. Again serves no additional purpose of diversification.
Ideal count of funds in your kitty
No fund manager or advisor can tell you the perfect number of funds that should form part of your portfolio. The best way to go is to have 6 to 8 funds that match your investment objective and can give adequate diversification as well as mitigate risks of investment. An ideal way would be to invest in maximum 1-2 funds of each category of equity funds namely, large cap, mid cap and small cap funds. 1or 2 debt funds or hybrid funds can also be added to the portfolio based on the risk appetite. In any case, most experts believe that an ideal portfolio should have not more than 8 funds from different categories.
There is a fine line between a diversified portfolio and an over diversified portfolio. The main thing to watch out for is to avoid excessive duplication of funds of the same category as well as invest in funds that do not match your risk profile. Hoarding of funds will ultimately dilute the returns and will also be cumbersome to manage with tracking of funds as well as the higher expense ratio of each fund. Thus, the ideal approach is to know the returns expectations, risk that can be managed and the budget for investment to limit the number of mutual funds in any portfolio.