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Does the advice to avoid more than four-five funds apply to portfolios with both debt & equity funds?

The benefits of diversification diminish rapidly after four-five funds even when debt funds are considered as part of the portfolio, informs Ashutosh Gupta

Value Research suggests that investors should avoid investing in funds beyond four or five. Does it apply to portfolios having both debt and equity funds as well? I want to build a 60:40 equity-debt portfolio with the help of equity and debt funds, not with hybrid funds.
- Krishna

Well, I would say there is no such hard-and-fast rule around the number of funds you should have in your portfolio. But we generally believe that diversification is important and one should diversify, but not go overboard. In our experience or whatever research we have done, the numbers suggest that beyond four-five funds, you only end up adding complexity to your portfolio and the benefits of diversification diminish rapidly beyond that.

In fact, we did a very comprehensive study recently, the results of which we published in our magazine Mutual Fund Insight sometime back, where we looked at the multi-cap category and ran an analysis on all possible portfolio combinations that were possible within the multi-cap category, ranging from portfolios of two funds to eight funds. Now, this exercise yielded portfolio combinations somewhere close to 48 lakhs. So that is suggestive of the breadth of this study and we considered a time period of the last 10 years.

Our study revealed that as we progressively added one more fund to a combination of funds in a portfolio, say we move from two funds to three funds or three funds to a portfolio of four funds, initially the benefits were meaningful in terms of reduced volatility in the portfolio as measured by its standard deviation over this holding period. But progressively as we moved beyond four or five funds, the incremental reduction in volatility was not meaningful.

So the idea is, beyond four-five funds, the benefits of diversification diminish rapidly. But on the other hand, you add on to the complexity of managing a bigger portfolio and at times, a large number of funds can also become a drag on the performance. That is why we believe that four-five funds is a good enough number for a portfolio. I would say that a similar principle holds true for debt as well. There is no point in spreading far too thin across too many funds which does not yield any meaningful benefits.

Now in his case, he talked about his desire to maintain a 60:40 allocation between equity and debt. I think he can very well manage that with a portfolio of five funds. So he can look to pick three equity funds and two high-quality debt funds and spread his money by allocating 20 per cent to each of these funds. With these five funds, he would be easily able to create a 60:40 asset allocation and once he does that, he should look to rebalance his investments on an annual basis and that should be good enough.