Deciding how many mutual funds to invest in is an important part of creating a diversified investment portfolio. The goal is to spread risk across different asset classes, sectors, market caps, and fund managers. However, over diversifying may also sometimes lead to reduced returns. So, what is the ideal number of mutual funds for an individual investor? Read on as we examine the benefits of diversification, risks of over-diversification, and provide guidance on how many mutual funds are ideal for different types of investors to meet their financial goals.
Importance of Diversification
Diversification is a key principle of investing that involves allocating capital across different asset classes, sectors, market caps, investment styles, and geographies. The aim is to reduce overall portfolio risk by avoiding overexposure to any single asset class or investment. Holding just one or two mutual funds leaves an investor vulnerable to the risks associated with those particular securities. For example, investing solely in a small cap equity fund exposes one mostly to the fluctuations of newer, small companies. Adding a mid cap equity fund can provide exposure to faster growing mid-sized companies, while further diversification may involve investing in a large cap fund to tap into the relative stability of well-established companies.
Spreading money across multiple mutual funds helps the positive performance of some investments to offset the negative performance of others. Also, a diversified portfolio combines assets with different risk/return profiles, providing a more balanced return potential.
The ideal number of mutual funds depends on factors like your investable assets, risk appetite, and investment timeframe. But holding 6-12 mutual funds across asset classes and fund styles is generally considered sufficient for diversification.
Risks of Over-Diversification
While diversification is important, over-diversifying may be detrimental. Holding too many mutual funds might seem like a way to reduce risk, but it may have the opposite effect by hampering the return potential.
For example, owning shares in too many companies via multiple equity funds might lead to the dilution of a great performance by a few investments. Had there been larger allocations, the well performing funds could have exerted a significant positive impact on overall portfolio returns.
Another drawback of over-diversification is less differentiation among fund holdings. Owning 15-20 equity funds often leads to repetition of the same large cap blue-chip shares in many schemes. The overlap reduces the actual diversification benefit.
Actively monitoring and rebalancing a barrage of mutual funds may be challenging for some investors, compared to them holding a more focused portfolio. Closely tracking fewer funds makes it easier to gauge whether they are on track to meet financial objectives. Staying updated on a large basket of investments is much harder. Also, with a large number of funds, higher expense ratios may eat into the net returns.
So, while some diversification is prudent, investors should be wary of going overboard and potentially hindering the return potential by spreading their capital too thin across too many mutual funds.
Ideal Number of SIPs for Different Investors
The ideal number of mutual funds to invest in via SIPs depends on the investor's risk appetite, investment amount, financial goals and time horizon.
For conservative investors, 2-4 mutual funds may be sufficient, focusing on a mix of debt funds, balanced funds, and large cap equity funds. Moderate investors may consider 4-6 funds, adding some mid cap equity funds. Aggressive investors with higher risk tolerance could choose 6-8 funds, further diversifying into small cap and sector funds. Beyond 8 funds, the return potential starts getting diluted without significant reduction in risk.
The available investable surplus also determines how many funds can be efficiently invested in. For those starting with small SIP investments of Rs. 3,000-5,000/month, investing in just 2-3 funds ensures sufficient exposure without being spread too thin. Investors parking Rs. 25,000-Rs. 50,000/month can consider diversifying across 4-6 funds while those with over Rs. 1 lakh investable monthly surplus can efficiently invest in 8-10 funds.
Longer investment horizons of 10-20 years allow picking more funds to benefit from compounding over time. But 6-8 funds spaced out across risks, sectors and styles is usually adequate for most retail investors.
The core principles are:
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Diversification across asset classes
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Avoiding too much mutual fund overlap and overcomplexity
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Investing enough in each fund to give it meaningful portfolio weightage
Striking the right balance depends on individual investor profiles and preferences.
Types of Mutual Funds for a Balanced Portfolio
Constructing a balanced mutual fund portfolio should incorporate different types of funds representing various assets, sectors and risk profiles.
Large Cap Equity Funds: These funds invest predominantly in shares of well-established large cap companies and are meant to provide relative stability to the portfolio. Limit exposure to 1-2 large cap funds.
Flexi/Multi Cap Equity Funds: These dynamic funds invest across market caps in large, mid and small cap companies. Can include 2-3 flexi/multi cap funds to provide holistic exposure.
Mid Cap Equity Funds: Funds that invest in mid-sized companies offer a middle path between large caps' stability and small caps' growth potential. Mid caps enhance overall portfolio growth potential. 1-2 mid cap funds may suffice.
Small Cap Equity Funds: Funds in newer, emerging small companies provide opportunities for outsized growth potential while also carrying higher risk. Include 1 small cap fund in moderation.
Sector/Thematic Funds: These funds target specific sectors like banking, pharma, infrastructure etc. and carry higher risk. Limit overall exposure to 1-2 sector funds.
Debt Funds: Bond and debt funds provide relative stability and income generation potential. Include 2-3 debt funds focused on different maturities and credit profiles.
Balanced Advantage Fund: A dynamic asset allocation fund that automatically balances equity and debt. 1 balanced advantage fund neatly incorporates both asset classes.
Index Funds: Passive funds that replicate market indices like Nifty 50 or Sensex provide low-cost diversified exposure. Add 1 index fund to access market-linked return potential.
More than 6-8 equity funds lead to overlap, so limiting overall exposure by investing higher amounts per fund may lead to the creation of a more balanced mutual fund portfolio.
Conclusion
Constructing a well-diversified mutual fund portfolio requires identifying mutual funds across various sectors, market caps, fund managers and risk profiles. It is prudent to limit overall equity exposure to 7-8 funds to avoid over-diversification. Investing in just 1-2 funds each in the large cap, mid cap, and small cap segments allows one to cover wider markets. Also, strategic debt fund investments may offer relative stability and the potential for income generation. Dynamic balanced funds incorporate equity and debt.
Aim for investing enough in each fund to derive meaningful exposure instead of thinly spreading across too many funds. Review asset allocation periodically and rebalance to address any drifts. Avoid overlap between funds and overcomplexity in portfolio monitoring. Sticking to these principles while diversifying across fund types can help one construct a balanced mutual fund portfolio aligned to one’s financial aspirations.
Disclaimer:
The above information is provided for information purposes only. It does not constitute any offer, recommendation or solicitation to any person to enter into any transaction or adopt any hedging, trading or investment strategy, nor does it constitute any prediction of likely future movements in rates or prices or any representation that any such future movements will not exceed those shown in any illustration. Users of this document should seek advice regarding the appropriateness of investing in any securities, financial instruments or investment strategies referred to on this document and should understand that statements regarding future prospects may not be realized. The recipient of this material is solely responsible for any action taken based on this material. Opinions, projections and estimates are subject to change without notice. The information contained in this document is not an investment, legal or tax advice. UTI AMC Ltd or UTI Mutual Fund (acting through UTI Trustee Company Pvt. Ltd) accepts no liability and will not be liable for any loss or damage arising directly or indirectly (including special, incidental or consequential loss or damage) from your use of this information, howsoever arising, and including any loss, damage or expense arising from, but not limited to, any defect, error, imperfection, fault, mistake or inaccuracy with this document, its contents or associated services, or due to any unavailability of the document or any part thereof or any contents or associated services.
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