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The Fewer the Merrier

To diversify your investments, how many mutual funds should you invest in? Is there a maximum amount of diversification beyond which you must not go?


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'Don't put all your eggs in one basket,' goes the proverb that we all learned in our school days. When we grew up and became investors, we learned that this was a basic virtue that was needed and was called diversification.

Fund investors take this as an injunction that they should invest not just in one or two funds, but in a large number 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. Is there an upper limit to this? 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 counterproductive and eventually it becomes ridiculous.

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Is there a point of diminishing returns? 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 diversification is provided 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. To understand, consider why we diversify. Diversification saves your from poor performance of 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 real 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-headed view of what diversification is and so thinks that more funds are good. It's not just a question of their being no benefit from investing in more funds, it's actually detrimental. Having too many funds in one's investment portfolio devalues one major advantage 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 percent 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.

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