Why is it not advisable to hold more than four funds?
Dhirendra Kumar provides insights into achieving effective diversification
May 6, 2019
I often hear that it is not advisable to hold more than two or four funds in your portfolio. However, I fail to understand the reason behind it, especially when the expense ratio remains the same. Kindly clarify.
We normally say that three or four funds can help you achieve reasonable and adequate diversification. However, this advice is not in terms of the expenses of your portfolio or making your portfolio economical. Also, the expenses for most mutual funds largely remain within specific ranges. Some big funds may have lower expenses, while smaller funds may have marginally higher expenses. But they will not be meaningfully different.
The basic premise for holding three-four funds in a portfolio is that if you have 15 funds, you will be exposed to diversification that might be counterproductive. This is because you may end up having a portfolio like that of an index fund while incurring the cost of an actively managed fund. Besides, there will be a lot of duplication in the portfolio. So, deliberate and meaningful diversification can be well achieved through three or four funds. Having more than that does not necessarily add any value to your portfolio. This suggestion, therefore, holds true not for expenses but for good enough diversification, rather than a counterproductive one.