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How Many Mutual Funds Do You Need in Your Portfolio

With a large number of mutual funds in the market, “how many mutual funds much is too much?” is now an essential question. When does diversification hurt?
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The famous American economist and author of The Intelligent Investor, Benjamin Graham (whom Warren Buffett is a huge fan of), said that

"Even with a margin in the investor's favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible. But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business."

Sounds a little complex? It isn't really. To put it in simpler words - when it comes to investing, diversification (investing across different asset classes) is vital.

However, overdoing diversification will not make much of an impact on the portfolio. Graham has advised the limit to be 30-40 stocks, after which the returns aren't substantially affected. Here's a graph to put that into perspective.

Graham - talked about removing risk related to individual stocks via diversification. However, the risk of the overall market still exists.

To remove market risk - investors can look at other asset classes such as International Equity, Gold, and debt.

std-dev-stocks

(Source: Investopedia)

So, is too much diversification a problem? How many mutual funds is the right number?

Even though mutual funds spare the investors the headache of investing in tons of stocks to diversify, too many mutual funds leads to the following scenarios:

  • Holding too many mutual funds is eventually going to mean that you are buying up the whole market at some point. As a result, your portfolio starts to look more and more like a financial market index. You might as well invest in index funds.
  • Investors may have the notion that buying multiple mutual funds helps in diversification. This is not true. Unfortunately, all domestic mutual funds in India tend to move in similar directions. So diversification across different schemes is not sufficient. What works is adding other markets such as the US. International markets and other asset classes such as gold and debt tend to move in different directions and, therefore, reduce risk.
Warren-Buffet-Wealth-Why-Invest-Early

To put it into perspective, diversification is necessary but loses meaning beyond 3-4 equity mutual funds. To reduce risk - don't add more mutual funds but other asset classes such as gold, international equity, and debt.

Some diversification tips for maintaining the perfect portfolio balance

  • Choose a diverse set of asset classes like equity, debt, International equity, commodities, real estate, etc. This approach reduces portfolio volatility and helps investors minimize the risk of one asset class performing poorly.
  • One equity mutual fund is adequate, but make sure that it's diversified across different sectors. Don't go beyond 4-5 mutual funds.
  • If you're looking to invest in debt funds and want to park your funds, choose liquid funds. But if you're looking for long-term debt funds, make sure your holding period is a long one.

So there you go. Find the perfect balance between diversifying and gaining high returns and invest accordingly. The tips mentioned above should come in handy when determining how many mutual funds to choose. Happy investing! For more, head over to Glide Invest.

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