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If you are investing in mutual funds, you may have asked or been told about diversification and the number of mutual funds you should own to make your portfolio stronger, and safeguard your investments from sudden market risks.
It is necessary to ensure that your investment portfolio is diverse and you don’t have all your eggs in one basket. At the same time, it is also true that too much diversification can prevent you from making high gains. This gives rise to the question of how many mutual funds you should have and how much is too much.
Diversification vs. overdiversification
Diversification of investments is done with the aim of spreading the risk out across a number of assets. If you have invested too much in the stocks of a single company, your investment is at greater risk, because if the company does not perform well, it’s share prices drop and so will your investments. To mitigate this risk, you should diversify your investments and invest in multiple companies, so as to ensure that even if one company does not perform well, the investments in the other companies helps you overcome that loss.
However, investing in too many companies can result in you not being able to make the most of your investments. Even if one of your investments does really well, you will not be able to see a great difference in your corpus because your investments are spread thin and the investment in any one company is bound to be smaller. It is usually suggested that you keep your investments diversified across industries, but limited to a few companies per industry.
How many mutual funds should you own?
Since there are several types of mutual funds, let us talk about each kind of mutual fund specifically.
Large-cap equity mutual funds make their investments specific to shares of large-cap companies. Investing in one large-cap mutual fund that is well researched and chosen diversifies your investments enough that a second one is not strictly necessary, but can be an option. Owning multiple large cap funds increases the chance that there is a significant overlap in the shares owned by these funds and does not really guarantee more diversity in your holdings.
Mid-cap equity mutual funds, as the name suggests, diversify their investment across companies belonging to the medium capital spectrum. These companies have much higher growth potential compared to companies belonging to the large capital spectrum. However, the risk involved with mid-cap mutual funds is also considerably higher.
There exist a lot more mid-cap companies than there are large-cap ones. This means that even if you invest in multiple mid-cap mutual funds, the chances that there is significant overlap in your investments is smaller. This means that you have more options to invest in, but only invest in mid-cap funds after you have throughly researched them and are confident in their prospects.
Though the high potential return can increase appeal for these funds, remember that there is a higher risk factor associated with these funds, which may be detrimental for your overall portfolio if things do not go your way. For mid-cap funds too, you should limit yourself to two funds only.
Small-cap mutual funds, as you can probably guess by now, invest in small-cap companies. Investing in them is a high risk, high reward strategy. If they do well, you stand to earn extremely high returns, but if they do not, you could lose out on a lot of your initial capital. Given the number of companies that fall in this bucket, the chances of your investments overlapping are smaller and the reason you should limit yourself to approximately two of these is more because of the risks associated with them. Again, only invest in small cap funds after a lot of thorough research.
Debt Mutual Funds are investment schemes that allocate your funds to bonds and other similar market instruments. These are considered very safe and low risk investment which means that the returns are also low. You can probably invest in one or two of these as well, but investing in more than that means lower returns overall.
Sectoral Mutual Funds allocate your funds to companies from one particular industry. This is very similar to investing in only one company, since if the industry as a whole sees a downturn, your investment in it will also take a hit. These funds are only a good option if you happen to be an expert in, or know a lot about, that particular industry. The number of sectoral mutual funds you invest in depends on the industries you are familiar with. If you’re not sure about a particular fund or industry, it is best pass on these them.
Though there is no exact number that is right for everyone, anywhere from six to ten mutual finds is usually the number of funds you want to be invested in. But this, by no means, set in stone. You could invest in more or less depending on multiple factors, such as your risk tolerance, your expected returns, your knowledge of particular industries etc. You should always ensure that the funds you are investing in are of different types, rather than funds with different names but similar outputs. As always, please research thoroughly and consult your financial advisor before making any financial decisions.
