You must have heard of diversification. Every investment advisor asks you to diversify your investments to safeguard it from sudden risks. But do you know you can overdo it? Overdiversifying can prevent you from making good gains! So the question now arises, how many mutual funds should you have?

 

Diversification of mutual funds

Diversification: how much is too much?

 

Over-Diversification of Mutual Funds

 

The aim of diversification is to spread risk. If you invest too much in one company’s stock, you are at great risk. If something happens to that company, a significant portion of your money could get wiped away. So to mitigate that risk, you buy shares of many companies. And to mitigate risk further, you buy shares of companies from different industries. So even if one entire industry is performing poorly, a good percentage of your money will still remain safe.

 

But if you invest in too many companies, and one of them does very well, your investment won’t gain much. The company that did well would have caused a very small impact on your total investment. So you should limit yourself to owning a few shares from most industries.

 

Sounds fair. But should you apply the same logic to your mutual funds? No, not really. This is because equity mutual funds themselves buy shares from very diverse industries. Typically, equity mutual funds at any point are invested anywhere between 50 to 100 shares. So when you invest in an equity mutual fund, you are indirectly owning shares of that many companies. Your portfolio is already very diversified!

 

How Many Mutual Funds Should I Own?

 

Mutual funds are of many types.

 

Large cap equity mutual funds invest only in large cap company shares. For example, HDFC Top 200 Mutual Fund, has investments in large cap companies like ICICI Bank Ltd (Financial Services), TCS Ltd (IT), Maruti Suzuki India Ltd (Automobile), L&T Ltd (Construction), and other such similar large cap companies.  Other large cap mutual funds hold similar shares.

Investing in many large cap mutual funds is not necessary. One well chosen large cap mutual fund should be enough.

 

Mid cap equity mutual funds invest in mid cap companies only. Mid cap companies grow at much higher rates when compared to large cap companies. At the same time, the risk is also much higher. For example, Mirae Asset Emerging Bluechip Fund invests in mid cap companies like Federal Bank Ltd (Financial Services), Ceat Ltd (Automobile), Voltas Ltd (Construction), and so on.

After careful research, you can consider owning a few mid cap mutual funds. The chances of overlap of ownership of shares is lower in the case of mid cap mutual funds because the number of mid cap companies is much higher.

 

Small cap mutual funds, as the name suggests, invest in small cap companies. Small cap companies are very volatile and can lead to meteoric rises and spectacular falls. The risk in case of small cap mutual funds is very high. For example, Reliance Small Cap Fund invests in companies like Seya Industries Ltd (Chemicals), West Coast Paper Mills Ltd (Paper), VIP Industries Ltd (Consumer Goods) and so on. The sheer number of small cap companies available to invest in is very high.

The chances of overlap of shares is lower in the case of small cap mutual funds. But it must be remembered, these mutual funds are very risky.

 

Debt mutual funds, invest money in bonds and other market instruments. They are low risk, low returns mutual funds. One such mutual fund is BNP Paribas Flexi Debt Fund. Debt mutual fund returns are very consistent over time and somewhat similar.

 

Sectoral mutual funds invest money in certain sectors or industries only. From a risk perspective, investing in a sector mutual fund is almost the same as buying shares in one industry only. You should have good knowledge of a certain sector to pick up a mutual fund in any given sector. DSP BlackRock Natural Resources and New Energy Fund is one such mutual fund.

 

So, how many mutual funds should you invest in? The answer to that, as usual, depends on you. Unless you are very well versed with the markets and have expert knowledge about mutual funds, a good rule of thumb would be to own:

  1. Large cap mutual funds: Up to 2. Maybe 3 at best. Beyond that, it doesn’t make sense as there will be great overlap in the shares owned by your mutual funds.
  2. Mid cap mutual funds: Up to 2. While you might get higher returns, the risk you expose yourself to is also higher.
  3. Small cap mutual funds: Up to 2. Given how high the risk is with these mutual funds, it is best to limit yourself to a limited number of small cap mutual funds. Also, avoid putting in a great percentage of your total mutual fund investment in small cap mutual funds.
  4. Debt funds: Ideally 1, but 2 is also good. Most debt mutual funds give you similar returns so it doesn’t make sense for you to own multiple debt mutual funds.
  5. Sectoral mutual funds: The number of sector mutual funds you invest in should be the number of industries you have great knowledge about. You should skip investing in these if you don’t have a very good idea of the sector the mutual fund is investing in.

So, about 8 (or +/- 2) mutual funds seem like the ideal number of funds to own. There is nothing wrong if you want to own significantly more or less number of mutual funds than suggested here provided your decision is well informed.