As a child, you may have heard of the popular proverb “ too many cooks spoil the broth”. This holds true when it comes to your mutual fund portfolio as well. While financial pundits constantly harp on having a diversified mutual fund portfolio to spread out your risks, it doesn’t take much for your portfolio to enter the over diversified zone. So how do you know your portfolio is diversified or has tipped towards over-diversification? What is the ideal number of funds to have? All this and more on what can spoil your mutual fund diversification is covered in the post ahead. Read on!
What do you mean by portfolio diversification?
Portfolio diversification in the mutual fund world means that you add a variety of mutual funds investing in different asset classes. This is a risk management strategy as investing in a wide array of assets helps you to reduce your risk levels. Concentration in only one asset could lead to heavy losses.
For example: Say you had a total of Rs 1,000 that you could invest.
Almost all equity funds across different categories of equity mutual funds are down by at least 20% on a year to date basis. Gold funds are up by 21% during the same timeline. This data is as of April 28.
Scenario 1: No diversification
Say you had invested Rs 1,000 in an equity fund.
Value of investment as on April 28 after pricing in a 20% reduction: Rs 800 approx
Scenario 2: Diversification
Say you had invested Rs 900 in equity funds and Rs 100 in gold (Experts always suggest not to exceed your investment in gold by more than 10% of your entire portfolio)
Value of investment as on April 20 after pricing in reductions: Rs 720
Value of investment as on April 20 after pricing in increase: Rs 121
Total Value= Rs 841
There is an increase of Rs 41, had you diversified.
In this article
Why Should You Diversify Your Portfolio?
With the help of the aforementioned example, it may have become clearer why mutual fund diversification is important. When it comes to building a mutual fund portfolio, the key to achieving your financial goals in a smooth manner is building a well-diversified portfolio. Here are the reasons why you having a diversified mutual fund portfolio may help:
To spread your risk: The purpose of diversification is to spread your investment risk across multiple investments so that an adverse movement in any one or two investments does not have a large impact on your portfolio returns.
Maximize returns: The corollary to spreading your risk and minimizing it is to maximize returns. Having a concentrated portfolio might also land you in a soup.
Especially during testing times when one asset class is trading in the red in really low levels, had you stayed invested only in that particular asset class, you would have lost big bucks.
Having a diversified portfolio helps you clock returns across assets, during different periods of time and accumulating more and more bucks.
To balance our shortcomings: If you compare equity and debt, equity is highly volatile and has a higher risk value, debt funds give moderate returns but are considered to be safer than equity. Both have their advantages and disadvantages. Diversification will help you to balance out the shortcomings of one with the advantages of the other.
Investing in different kinds of funds invested in different asset classes reduces your odds of losing money.
Things to keep in mind about portfolio diversification
When you’re thinking over how to diversify mutual funds in your portfolio and you’re researching on strategies and funds and different avenues you can invest in, there are also some caution points you can consider:
Diversification means ‘variety’: Diversification works well only if the investments in the portfolio are markedly different from each other ie. they are uncorrelated.
Many investors have the misguided view that risk is proportionately reduced with each additional mutual fund investment in a portfolio, when in fact this couldn’t be farther from the truth.
Multiple investments in different mutual funds in the same asset class doesn’t serve the purpose.
Covers risk only till a certain point: There is strong evidence that you can only reduce your overall mutual fund portfolio risk to a certain point beyond which there is no further benefit from diversification.
Optimal diversification is possible not by adding a large number of mutual funds to your portfolio but by adding a number of uncorrelated mutual funds to your portfolio.
How To Spot If Your Mutual Fund Portfolio Is Overdiversified
Over diversification is that well you need to prevent yourself from falling into. In the spirit of diversification and getting the most of all, you might end up in over-diversification. Worry not, because we’ve got you covered. In this section, we will learn about how you can spot over-diversification and what are the drawbacks that come with diversification and can be multiplied if you overdo it.
Here’s how you can spot over-diversification in your portfolio:
Owning too many mutual funds within a single category – When building a diversified mutual fund portfolio, the idea is to invest in different types of mutual funds such that you have multiple sources of returns and the overall risk of the portfolio is mitigated. However, if you have invested in multiple funds of the same category then it is most likely that your mutual fund portfolio is over-diversified.
Any single news flow or development has a disproportionate impact on your overall mutual fund portfolio – this is an important indicator of over-diversification. If despite investing in multiple mutual funds, a single news flow or macro-economic development can have a disproportionate impact on your overall mutual fund portfolio, then it is likely that your mutual fund portfolio is over-diversified.
Drawback with over-diversification
While we have discussed the fruits that diversification can give us we should also be aware of the drawbacks.
- Tracking performances: If you had way too many funds in your basket than required, then tracking each and every fund category and asset classes of those categories will become extremely difficult.
- Costs: Every investment also adds a cost to your wallet. Be wary of the charges of the funds you are investing in. Overdiversifying will have a huge cost burden in terms of extra brokerage fees, expense ratio, management fees in cases of certain funds and so on and so forth
How Many Funds Are Ideal For A Diversified Portfolio?
This is one of the most common problems faced by investors who want to know more about how to diversify mutual funds. Unfortunately, there isn’t a magic number. The optimal number of funds depends on multiple factors that include your investable amount, investment goals, and risk profile. There is no correct number of mutual funds for diversification. However, there are few things investors can consider in their quest to build the best diversified mutual fund portfolio.
- Determine the different categories, themes, and strategies of funds you want to invest in to create your mutual fund portfolio – you can spread your mutual fund investments across-asset classes (debt/equity/hybrid), themes (sectoral), and strategy (dynamic/arbitrage), etc.
- Ensure that you do not buy more than 3-4 funds within each category – Once you have determined the category, ensure that you do not have inordinately high exposure to any one category. However, this decision will have to be made after taking into consideration your financial plan and should reflect your risk/return profile.
- Ensure that you are diversified within a category as well – Once the category has been determined, ensure that there is not a high amount of overlap within a category.
For example: assume that you want to create a 40% exposure to equities. Now, within equities, it would be wise to invest in mutual funds across market capitalizations and themes rather than invest in only one type, say large-cap, of the mutual fund. For equity mutual funds, you can have around 3-5 funds in your mutual fund portfolio, which are spread across different market segments and fund management styles.
The Final Word
To sum up, it is extremely important to know that diversification is not a game of numbers but about investing across a range of companies, sectors, and asset classes by using mutual funds as the instrument.
Don’t add funds in your portfolio just because your friend suggested it to you or you saw it in the news that so and so the fund has been doing well and it would be a good idea to add it to your already loaded portfolio. Adding too many funds also increases the headache of tracking their performance which is an absolutely essential activity. Also, there is no fixed or ideal number of mutual funds for diversification.
Monitor the performance of the existing funds in your portfolio. Only when you feel some of these funds are consistently giving poor results and weighing your portfolio down, should you choose to stop investing in them and select better funds in the same category.
However these maybe just a matter of a business cycle and returns may resume in the coming times.
Do remember that how much ever your portfolio may be diversified, it can never mitigate risks completely or 100%.
Even diversified investments are subject to market risks. So keep periodically reviewing your portfolio and the mutual fund market, in general, to ensure you are well on your way to achieve your financial objectives.