How Many Mutual Funds Do I Need? Beginner’s Guide to Portfolio Construction

Table of Contents:

Introduction:

Ever wondered how many investment funds are “just right” for your portfolio?

How many mutual funds should be there in your portfolio?

Is it better to invest in one mutual fund or multiple?

Are 10 mutual funds too many?

The answer, like most things in investing, is it depends! This article will explore how to find the ideal number of funds to balance diversification and manageability in your investment strategy.

Diversification means spreading your money around across different investments to avoid putting all your eggs in one basket. Manageability refers to how easy it is to track and oversee your investments. With too few funds, you might not be diversified enough. But with too many, it can become overwhelming to keep tabs on everything.

We’ll explore how to consider your risk tolerance, investment goals, and the makeup of the funds themselves to find the sweet spot for your portfolio.

There is no “Magic” Number.

Determining the appropriate number of funds to expand your investment portfolio is a pivotal decision, yet there’s no universal formula. The range can vary greatly, spanning from as few as two funds to a multitude.

Therefore, the decision ultimately rests on a careful assessment of your circumstances and preferences. Whether you opt for a minimalist approach with just a couple of funds or embrace a more extensive strategy with numerous investments, the key lies in creating a portfolio that aligns with your goals and effectively manages risk.

The optimal number of funds to hold in your investment portfolio is influenced by various factors, among which the experience each investor has in the markets is paramount. In this article, we will explore how individual experience levels can inform the decision-making process and help determine the ideal number of funds for each investor’s portfolio

Before we begin to dive into the topic of how many funds are needed, let’s try to understand why people look out for new funds.

Why do we look for new Funds?

Well, there can be 2 possible scenarios where people are fond of investing in new funds in addition to their existing funds.

1. NFO Euphoria:

New Fund Offers (NFOs) often generate a buzz in the investment world, tempting investors with promises of exciting opportunities and potential profits. However, it’s essential to approach NFOs with caution and discernment. While some NFOs may indeed offer valuable investment prospects, not all are suitable for every investor. Just ask yourself 2 simple questions.

• Q1: Is this NFO Unique in any way so much so that it is going to take the industry by storm?
• Q2: Is this NFO any different from your existing portfolio of funds?

If the answer is Yes, then you can consider investing in the NFO.

Blindly investing in all new NFOs can expose investors to unnecessary risks and uncertainties, potentially undermining their investment goals and may also lead to overlapping in most cases.

2. Beware of Performance Chasing:

Avoid simply adding funds based on current performance or recommendations from your relationship manager, as this could result in fund overlap. Overlapping funds may negatively impact your portfolio’s performance if the top-performing fund experiences a downturn.

When considering a new fund suggestion, ask your relationship manager to determine whether it indicates poor performance in your current funds and if replacing any underperformers with the new fund is necessary. Additionally, assess whether adding the new fund will enhance your portfolio diversification or strategy.

How many funds do beginners need?

Let’s now get into business and see how much funds we need.

As a novice investor, you may find yourself uncertain about the number of funds to purchase and how to diversify them effectively for optimal returns. However, determining the appropriate number of funds can be challenging.

Let’s discuss how many funds you should consider acquiring when initiating a mutual fund portfolio. First and foremost, it’s essential to understand a straightforward concept: you needn’t stress over comprehending various styles and strategies, as they can be complex to grasp initially. Instead, a practical approach is to commence with a modest selection of 2 to 4 funds, particularly if your available surplus is limited.

Option 1: Choosing how many investment funds to hold can be tricky at first. If you’re starting small, with monthly contributions of Rs 5,000-10,000 or a lump sum less than Rs 50,000, you can keep things simple with 2-4 funds. This way, you can focus on understanding your investments without getting overwhelmed by managing too many choices.

When you’re only picking 2 funds, you can’t choose both high-risk ones, like mid-cap and small-cap funds. Instead, it’s better to go for diversified equity funds like a flexicap fund and a low-risk debt fund. This helps balance your portfolio and reduce the chance of big losses.

Option 2: When looking at a 1–3-year timeframe, it’s important to understand that the stock market can be unpredictable, with prices changing rapidly. A hybrid fund is a type of investment that includes both stocks and bonds.

Stocks have the potential for higher returns but also come with more risk, while bonds are typically safer but offer lower returns. By having a mix of both in your portfolio, you can potentially reduce the impact of any losses that occur. This combination aims to strike a balance between the potential for growth and the stability of your investments.

Option 3: Another simpler yet effective option to consider is to invest in a large-cap passive index fund in conjunction with a low-risk short-duration debt fund.

Passive index funds are designed to track specific market indices, such as the Nifty 50 or Sensex, without actively selecting individual stocks. Because these funds passively mirror the performance of the underlying index, they typically require less diversification compared to actively managed funds.

By opting for a large-cap passive index fund, investors can simplify their portfolio management while still enjoying exposure to the broader market. These funds offer a cost-effective way to invest in a diversified portfolio of stocks, making them suitable for investors seeking long-term growth potential with minimal effort.

Additionally, including a low-risk short-duration debt fund in the portfolio adds a layer of stability. Debt funds invest in fixed-income securities like government bonds and corporate debt, providing regular income and capital preservation. A short-duration debt fund focuses on shorter-term bonds, which are less sensitive to interest rate fluctuations and offer relatively stable returns.

You may wonder if holding just 2-3 funds exposes you to a high level of risk in each fund. The answer is yes, it does increase the exposure to each fund. However, it’s crucial to understand that the impact of a loss depends on the overall size of your investment portfolio.

As your investment corpus grows larger, diversifying across different asset management companies (AMCs), particularly in debt funds, becomes increasingly important. By spreading your investments across multiple AMCs, you can reduce the concentration risk associated with any single fund or fund manager.

This diversification strategy helps mitigate the impact of potential losses and provides a layer of protection for your investment portfolio, especially as it grows in size.

How many funds do Seasoned investors need?

Now that you have navigated through the rough seas, you are at ease with how mutual funds work. As your needs grow you decide to extend the number of funds to suit your goals. So, what should this number be?

Well, again it’s not fixed and may vary from person to person.

As you invest more money, you might think about adding more funds to your portfolio, ideally between 6 to 10 funds. If you mainly have investments in things like bonds or loans, known as debt instruments, you might need even more funds from different AMCs. This makes sure you spread your money out enough to be safe.

Having 6-10 funds for all your goals means each one makes up about 10-17% of all your investments put together. This is a good limit because it gives each fund room to grow and become about 20-25% of your total investments, which is okay.

But remember, this isn’t a strict rule. It can change depending on how you invest.

For example, if you choose to mostly invest in things called passive funds, you might only need 4-5 of them. As explained earlier, these funds don’t need a lot of attention because they just follow the stock market instead of trying to pick the best stocks.

With fewer funds, you reduce the risk of putting too much money in one place, especially if you pick good quality funds that don’t make big mistakes.

When you’re deciding which funds to add to your portfolio, it’s important to think about different kinds of investments rather than just picking from different categories. If you add funds from every category like a large cap, one flexicap, one multi-cap ,one large & midcap, you might end up owning a lot of the same stocks in different funds.

That’s not good because if those stocks do badly, all your funds could lose money at the same time.

If you’re not sure if your funds have too many of the same stocks, you can use tools to help you figure it out. Tools like Fundoo help us achieve this. These tools can show you if your funds are too similar and help you choose more diverse funds.

So, as your investments grow, think about adding more funds to spread your money out and make sure it’s safe. But don’t forget, the number of funds you need can change depending on how you invest. If you keep it simple and choose good-quality funds, you’ll be on the right track.

Why do you need more investing Styles/Themes?

As an investor, you must know why we are so much into “mixing different styles.” Mixing styles promote GARP (Growth at a reasonable price) to the best possible measure. Not only this but mixing styles is also much more effective than buying different funds and going all in.

This also protects us from the downturns that each asset class faces.

Below are the returns across the whole spectrum of investments. This is also one of the reasons to go in for different styles of investing.

What can you do as an investor here?

Here are some key techniques you can follow to get the maximum out of your invested money.

1. Mixing Investment Styles: Try to incorporate growth, value, GARP (Growth at a Reasonable Price), and hedging strategies in active funds for better diversity.
2. Add Some Passive Funds: If you don’t have a Professional Mutual Fund Distributor or a Certified Financial Planner, then selecting actively managed equity funds that can generate additional (alpha) returns will be challenging. In that case, adding passive funds reduces the need to go and outright diversify your portfolio manually. So, simply Including index funds like Nifty 50 or Nifty 500 to just maintain market performance can be a safe move.
3. International Exposure: For long-term portfolios (five years or more), consider adding passive international funds, particularly US-focused ones, for diversification.
4. Gold Allocation: Many investment analysts don’t talk about the importance of adding gold to your investment portfolio. Gold serves as a diversifier for long-term portfolios. But avoid adding it to short-term portfolios? Well, because gold has high volatility. You can simply go for one gold fund.
5. Learn Flexible Style Mixing: It’s not necessary to have one fund from each style. You can also adjust “style mixing” based on portfolio goals and timeframes.
6. Experimentation Over Time: Longer time frames allow for more experimentation with value-focused or growth-focused strategies. So? Adjust portfolios accordingly, such as adding antagonistic strategies for longer-term goals.

Why is having too many funds in your portfolio a problem?

Well, the reasons are quite obvious.

Over-diversification: While diversification is a fundamental principle of investing, having too many funds can lead to over-diversification. When you spread your investments across numerous funds, particularly those with similar holdings or strategies, you may dilute the potential benefits of diversification.

Increased Complexity: Managing a portfolio with a large number of funds can become complex and time-consuming. Tracking the performance, expenses, and holdings of each fund becomes more challenging as the number of funds increases. This complexity can make it difficult to monitor and adjust your portfolio effectively over time.

Higher Costs: Owning multiple funds typically results in higher investment costs. Maintaining a large portfolio may require more frequent transactions, leading to increased exit charges and taxes.

Potential Overlapping Holdings: When you invest in numerous funds, especially those within the same asset class or sector, there’s a risk of overlapping holdings. This means that you may inadvertently hold the same stocks or securities across multiple funds, resulting in redundant exposure and reduced diversification benefits.

Performance Drag: The presence of too many funds in your portfolio can lead to performance drag. Some funds may underperform or have higher expenses, dragging down the overall performance of your portfolio. Additionally, the effort and resources required to manage a large number of funds may detract from your ability to make timely investment decisions or react to changing market conditions.

Conclusion:

Managing a well-balanced investment portfolio requires a thorough analysis of various factors. From selecting the appropriate mix of funds based on investment styles and objectives to avoiding the dangers of over-diversification and chasing performance, investors must strike a balance.

There’s no one-size-fits-all approach when it comes to the number of funds in a portfolio. While the above article offers practical ideas for limiting and managing a portfolio, ultimately, it’s up to individual investors to customize their portfolios according to their preferences and goals.

By adopting a focused approach initially and gradually expanding the portfolio with a suitable mix of investment styles and strategies, investors can aim for favorable returns over the long term.

Happy Investing!!