How Many Funds Should I Have in My Portfolio? A Comprehensive Guide

As an investor, one of the most common questions you may ask yourself is, “How many funds should I have in my portfolio?” The question often raises doubts and uncertainties, as there is no one-size-fits-all answer.

The ideal number of funds in a portfolio depends on various factors, including investment goals, risk tolerance, and time horizon. While some experts advocate for diversification through many funds, there are compelling arguments for a more focused approach.

How many mutual funds should you hold?

Many investors believe that having more funds in their portfolio automatically translates to better diversification and reduced risk. However, this conventional wisdom may not always hold. In fact, managing too many funds can lead to inefficiencies and lower returns in the long run.

When examining the statistics, it becomes apparent why outperforming the index in the long run with multiple funds is challenging. The SPIVA report reveals that over the last five years, a substantial 82% of large-cap schemes have underperformed their respective benchmarks. Similarly, 76.9% of Indian ELSS funds have failed to match the index’s performance. While there has been some improvement over a 10-year period, with 63.9% of funds underperforming the benchmark and 54.9% of Mid-Cap fund managers underperforming the index over 10 year period.

These statistics clearly demonstrate that active mutual funds generally deliver lower returns compared to the index. Several factors contribute to this underperformance, including changes in fund managers, increases in assets under management (AUM), higher expense ratios, and turnover ratios. It is therefore imperative for investors to carefully consider their portfolio composition and investment strategies.

It is crucial to understand that diversification does not imply investing in as many funds as possible. Diversification aims to reduce the risk or volatility of a portfolio, which can be achieved by considering statistical parameters such as the standard deviation, beta, and Sharpe ratio of a mutual fund.

For instance, comparing a portfolio consisting of six funds with an 18% standard deviation to another portfolio comprising thirty funds with the same standard deviation, both portfolios would carry similar levels of volatility. Merely investing in different combinations of funds without assessing the associated risks should not be considered true diversification.

Creating a portfolio with 5 to 7 well-selected funds helps diversify your investments and reduces reliance on just a few. This increases your chances of getting better returns that match your investment goals. On the other hand, having too many funds, like 10 to 30, can lower your returns because some may not perform well, hurting your overall portfolio. So, it’s better to keep it simple and focused with a smaller number of carefully chosen funds.

How to minimize risk and maximize returns?

In India, there are more than 30 categories of mutual funds that cater to different investor needs. Some funds have very low risk and invest in bonds, while others are equity funds that have consistently delivered positive returns with an average of over 10% in the past 10 years.

17 Equity Mutual Funds with Positive Returns Every Year

It’s important to choose a fund based on your specific needs. For example, if you have a short-term goal of 3-5 years, like saving for a Car or CLearing loan, it’s not suitable to invest in infrastructure or pharma funds, as they may not provide decent profits with low risk. On the other hand, if you have a long-term goal, like retirement planning, investing in an equity savings fund may slow down the growth of your portfolio.

To lower risk and maximize returns in your portfolio, it is suggested to understand your specific investment needs and select the fund accordingly. Consider factors such as your investment time horizon, risk tolerance, and financial goals before making your decision.

What will happen if I invest in more than 3 funds within a category?

Let’s imagine you started investing in 5 flexi cap funds back in 2016. You allocated 20% of your portfolio equally to each fund based on their past returns, as shown in the table. At that time, the funds seemed promising, with a 5-year average return of 20%, which was 5% higher than the NIFTY 500 TRI index. The 3-year average return was even better at 21%, compared to the index’s 13.76%. These returns made you hopeful for greater returns from these funds compared to the index.

Now, fast forward to 2023, after 6 years of investing. Unfortunately, only 2 out of the 5 funds managed to deliver returns higher than the index. The average return of all 5 funds turned out to be lower than the index. This means that all the funds were lagging behind in 2023, resulting in lower overall returns. As a result, investors lost interest in these funds.

5 Flexi Cap Funds 2023

This situation highlights the consequence of over-diversification. Including underperforming funds can drag down the overall returns of your portfolio. It’s important to understand that too much diversification can dilute the impact of potential winners and make managing your portfolio more complex.

To maximize returns and manage risks effectively, it’s wise to strike a balance when diversifying your investments. Carefully choose a few well-performing funds that align with your investment goals. This approach will help you avoid the pitfalls of over-diversification.

In conclusion, the statistics presented strongly support the notion that actively managed funds struggle to consistently outperform the market. While investing in a top mutual fund does not guarantee superior returns, constructing a portfolio of 5 to 7 carefully chosen funds across multiple categories can increase the chances of beating the index by a modest margin of 1-3% over the long term. However, it is crucial to avoid over-diversification, as this can lead to underperformance due to a higher proportion of underperforming funds within the portfolio.