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What's the magic number?

How many funds should you invest in? Is there such a thing as too much diversification?


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What

Every child has heard the saying, 'Don't put all your eggs in one basket'. The investing version of this idea is diversification and every investor knows that diversification is good. For mutual fund investors it means that they should not invest in just one or two funds, but must spread their investments across lots of funds. So they decide that investing in two funds is better than one, three is better than two, four is better than three and so on. Where does this stop? Is investing in 10 funds better than 9? How about 20? Or 50 or even 100? At some point diversification becomes pointless, and then it becomes counter productive and eventually it becomes ridiculous.

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Of course, most investors would think the limit of diversification to be a strange idea. A few years ago, someone asked me how many funds should he invest in. I said that three or four was a good number. Later, the person mailed me his portfolio and I realised that while the sense of my answer was that he should invest in no more than three or four funds, he had assumed I'd meant a minimum of three or four.

Investors think that the way to achieve diversification is to invest in lots of funds. However, the truth is that no additional benefits of diversification ensue by investing in more funds beyond a certain point. Mutual funds are not an investment by themselves. They are a way of holding the underlying investments which, for equity funds, are stocks. The reason why too much diversification is pointless is that the stocks held by similar funds tend to be a similar set. Beyond a small number, when you add more funds, you are generally adding more stocks that are similar or identical to what you already have.

This is not diversification. Let's recap why we diversify. Diversification saves you from poor performance from a set of investments. If a particular company or sector does worse than the markets in general, then having only a small part of your money exposed to it helps. Diversification could also be across company sizes as sometimes only smaller or larger companies do well or do badly. It could also be geographical. Diversification does nothing for you when the entire market declines.

The reason most investors invest in too many funds is that someone sells it to them and earns a commission. The investor does not have a clear view of what diversification is and so thinks that additional funds are good. It's not just a question of there being no benefit from investing in more funds, it's actually detrimental. Having too many funds in one's investment portfolio devalues one of major advantages of investing in mutual funds, which is convenience of tracking and evaluating one's investments. Have investments in a large number of mutual funds makes this exponentially more difficult. Periodically, perhaps once a quarter, investors should evaluate each fund in their portfolio and see if it's contributing what it's supposed to. However, when you have 15 or 20 funds, most of them bought because some salesman delivered a hard pitch, then this exercise is impossible. There will be funds which are 2 or 3 per cent of your portfolio and it's hard for you to figure out what they are doing there, what you should expect and what difference it would make if they were doing well or badly. It's hard to work towards meeting your financial goals when you can't evaluate and manage your portfolio because it's bloated.

The sweet spot for the ideal number of funds tends to be three or four, anything more is a waste of effort. In fact, depending on the size of someone's investments, it could be even less. For someone investing perhaps five or six thousand rupees a month, one or two balanced funds are ideal and anything more than that is pointless.

Remember, mutual funds themselves encapsulate diversification, adding more funds achieves very little.

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