The number of different schemes should one invest in?
Having the same kind of different funds is called 'overlap.'
Diversification is a procedure of investing across different asset classes
If you ask, in how many different schemes one should invest, it depends on several factors, including risk tolerance and investment objective and a few smart, strategic rules. Two terms are essential to know in this regard, one is the investment portfolio, and another is diversification of the portfolio.
An investment portfolio refers to a group of investments that an investor uses to earn a profit and ensure that capital or assets are preserved. It is a set of financial assets that may include bonds, cash and cash equivalents, currencies, stocks, and commodities.
Diversification, on the other hand, is achieving variety in the portfolio. While planning investment in mutual funds, it essentially means reducing overall portfolio risk by holding a variety of funds representing different categories and asset classes.
Is your portfolio diversified?
The essence of diversification follows a phrase you know very well, and that is, “don’t put all your eggs in the same basket.” From the context of investment, it means if you put all of your money into one investment, you are probably not diversified. However, at the same time, spreading money among many different mutual funds but of the same type or class does not also mean diversified! Here funds are too similar to provide the kind of diversification that is required to spread risk. Having the same kind of different funds is called ‘overlap.’ Avoid overlap with mutual funds, and make sure that funds you are holding are truly from different fund categories.
What is diversification in mutual funds?
The objective of diversification is to reduce risk, increase returns, and to ensure stability in funds’ performance over a period. If these three objectives can be achieved with lesser schemes, then why go for more? Simple four to five fund allocations that include one large-cap stock, one small-cap stock, one foreign stock, and one bond fund could be enough to achieve diversification. Each of these funds will possibly hold securities that are entirely different compared to each other.
Diversification is a procedure of investing across different asset classes based on your financial horizon as well as your risk appetite to maximize profits.
Is there any ideal number of funds to be diversified?
A very common question often asked is the number of mutual funds that is best to have a diversified portfolio. It is possible to have just one fund and be diversified. The fact is, a single mutual fund often holds 25 stocks from different sectors, and if you have about three such generic equity funds, you will likely hold most of the top 100 market stocks. In case you are choosing just two, it could be a stock index fund and a bond index fund and achieve proper diversification. In any case, there should not be more than 10 to be fully diversified. More funds will only lead to the overlapping of the same stocks, not further diversification.
A solid portfolio with five to seven mutual funds can help to be completely diversified. However, the right kind of just a few mutual funds, which are called balanced funds, can diversify your portfolio successfully. And even if you have gone for several thematic funds, more than 2 to 3 themes are unlikely to succeed at any given time. Therefore identify these 2-3 themes and invest instead of throwing several darts in all directions.
There is one thumb rule fund advisors suggest based on their experience in mutual funds and stocks is that three well-chosen mutual funds can give all the diversification one needs. More only add complexity, and likely to lower returns. There are expert fund managers who are dedicated to managing your money well. Even if you have no time or interest in finance, three funds can take care of your needs pretty well.
Factors determining the number of different schemes one choose to invest
Determine the time when you would require the money:
- If you need the money within 3 years, i.e., in the short-term, then go for debt funds.
- If you may require the money between 3-5 years, i.e., in mid-term, then go for balanced or hybrid funds.
- For any time horizon above 5 years, i.e., in the long-term, then go for equity funds.
- If you want to meet life goals like higher education, retirement, marriage, purchase of a home, etc. i.e., core needs, then go for a diversified large-cap fund or an index fund.
- If it is for general wealth creation, which is called satellite needs, choose either a thematic or sector fund.
Why should one limit the number of schemes?
If you carefully look at your portfolio, you will find that the names of most funds are different, but they often hold very similar stocks. As the saying goes, “too many cooks spoil the broth,” once the number is above the desired limit, it is not possible to keep track of changes in dividends, expense ratio, fund managers, and investment objective. An outperforming scheme may cover an underperforming scheme, and you may hold it for long.
Therefore a large number of schemes would not only make it difficult to monitor the performance of the schemes regularly but also make it challenging to take remedial actions if some schemes are not performing well. It doesn’t mean that ‘more the merrier’ and you would invest in every available investment options. Consider every option carefully before including it in your portfolio.
As an investor, consider a mix of growth and valued funds. Avoid investing in multiple schemes of the same type managed by the same Fund Managers. Also, see that a fund manager should manage a maximum of 10% to 15% of funds. Your portfolio investment should be like 50 % in the large-cap category for safe, constant return, 30% in mid-cap funds which have chances of exponential growth and higher return in a short period, but the risk factor is more and 20% in multi-cap where your fund manager invests on a combination of large and mid-cap based on his market view. Nowadays, tools are also available to analyze your portfolio and avoid overlapping. Go for it!
That’s why Comparte Investment team asks do you have “Nivesh Ki Aadat”.
With this one can say “Mutual Fund Sahi hai”, so let me do Nivesh