How Many Mutual Funds Should You Invest In?

It’s worrying that so many new investors mistake duplication for diversification.

The most common question that new investors (or even existing investors) want an answer to is “How many mutual funds should I have in my portfolio?” The actual number is probably very different from what you think.

Before coming to the answer, let us understand the reason behind this confusion – Investors want to have a properly diversified portfolio. Diversification is the main objective here. Therefore it is important that we should address this diversification issue.

The famous saying “Don’t put all your eggs in one basket” is the essence of diversification. Mainly, it means not limiting your investment to a single avenue but spreading it across different areas in order to mitigate risk. If you limit your investment to one company stock you are at the highest risk. What if the company gets involved in a major scandal tomorrow? Its stock price would tumble & you would lose all your money! So to avoid such risk you invest in many different companies and to mitigate risk further you invest in companies from different sectors as well. Even if one sector or industry is going through a dull phase, other better performing sector might help and cover those losses. Therefore, the best strategy here would be to diversify your investment by owning few shares from all sectors.

While the above logic is well and good for direct equity investing, it causes problems when you apply the same logic to your mutual fund investment. The biggest and the most common mistake most investors succumb to is thinking that they are properly diversified by spreading their investment money in many different mutual funds.

You need to understand the fact that equity mutual funds themselves invest in shares from very diverse industries. A single equity mutual fund portfolio on an average consists of shares from around 40 – 60 companies at any given point. So when you invest in an equity mutual fund you are indirectly investing in shares of that many companies, hence your portfolio is already very diversified. In fact one of the main advantages of investing in mutual funds is the quality of diversification that they provide to your investments. The fund managers generally opt for a well diversified portfolio by investing in multiple avenues. They invest not just across different companies but also across different sectors and size of companies.

Investing in too many funds will not provide the desired diversification, because stocks or underlying holdings in many of such funds tend to be similar or overlapped, which means that you end up placing your money in same companies again & again. Buying mutual funds from the same category will have you investing in similar/same set of companies over & over. For investor of mutual funds the main diversification required is between different fund managers.

When you have too many mutual funds, you can easily lose sight of the forest for the trees. It is difficult to maintain a huge portfolio and keep track of all the investments. You will fail to notice a major shift in fundamentals of one or more funds, which can cause you dearly. Also, when you start investing in many different funds in the name of diversification, you start behaving like a collector instead of an investor with defined goals. It is vital to know how much is enough.

There are no “right” number of mutual funds for your portfolio, it would depend on your investment goals, risk appetite and time horizon. But it’s easy enough to say that you don’t need dozens of funds in your portfolio.

A model portfolio for a investor looking for wealth creation with long term horizon and good risk appetite can be:

  • 2 large cap funds (limited number of large-cap companies, chances of overlapping is high)
  • 2 – 3 mid cap funds (too many mid-cap companies, chances of overlapping is low)
  • 2 – 3 two small cap funds (too many small-cap companies chances of overlapping is low).
  • 1 or 2 balanced or debt funds as a cushion

Or you can invest in 4 – 5 diversified equity funds instead of selecting large, mid and small cap funds separately. You would arrive at the same level of diversification in either way, provided you keep in mind to avoid major overlapping of holdings.

Keep in mind that this number of funds in your portfolio does not include pass through funds that you use as vehicle for STP, as it will be of zero value in future.

If you go for more funds than required it is likely that you would end up having many funds that are practically doing the same thing.

If you own a scattered portfolio take these steps and consolidate your investments to a limited number of funds. This will definitely help you in the long run.

  1. First consider your objective: if wealth creation is your main goal then investing in debt funds only is the wrong strategy, similarly if you are looking for capital protection or preservation then a small or mid cap fund is not needed.
  2. Once you have finalized the mix of funds that you wish to invest in, find out their underlying holdings. If two or more of your selected funds have significant overlapping, eliminate some of those funds. There is no point in having multiple funds with the same underlying holdings – that is not diversification, that’s duplication!
  3. For eliminating you can consider two factors: first the performance, keep the better performing fund and discard the other. Secondly look at the expense ratio, if two funds have similar holdings opt for the lower expense ratio. After all, a penny saved is penny earned.
  4. Another important thing to keep in mind is that you should not limit yourself to one Asset Management Company only, invest in funds from different fund houses to mitigate the risk, some fund houses have an expertise in investing in one sector while others are the experts of another sector.

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