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How many funds are needed to achieve adequate diversification?

There is a right amount of diversification, and having too much is pointless while too little is risky

How many funds to achieve adequate diversification?

Diversification is the most valuable quality that mutual funds bring to your investments. However, there is a correct amount of diversification, and having too much of it is pointless, just as having too little is risky. Mutual funds provide an easy way to solve this problem.

The idea of diversification is straightforward. Stocks of different kinds of companies tend to do well or do badly at different times. By 'different types of companies' one could mean companies from different sectors, different parts of the world, or with varying financial parameters like different levels of interest cost or forex exposure.

In any well-managed fund, this spread is balanced not just across different companies but also across different sectors and sizes of companies, thus providing optimum safety. For the investor who is putting his money in funds, the only diversification that is needed is between different fund managers.

In our judgement, four or five funds are enough to provide this kind of diversification. No additional diversification is provided by investing in more funds. The reason is that the stocks held by these funds tend to be a similar set. With a larger number of funds you are effectively adding more funds similar to some other fund that is already there with you.

Too many funds take away from the major attraction of investing in mutual funds in the first place, which is convenience. Having to keep track of a large number of mutual funds simply adds to your work. At least once a quarter, such an investor would have to look at each fund's performance, give some thought to how it's doing, whether it's living up to the purpose for which it was bought. This exercise would make sense only if some purpose was being served by having many funds, but that's not the case.

Generally, ownership of too many funds is driven by a salesman's push rather than any intrinsic need that an investor has. What you do need to ensure is that the small number of funds you have are of different types and are managed by different fund managers.

This story first appeared in November 2013.