One reason why people invest in mutual funds is to diversify their investment across various asset classes, sectors and companies. Thus, mutual funds themselves are a diversification vehicle, with each scheme investing in a minimum of 30-40 stocks.
Let’s see some examples of what happens when you invest Rs. 30,000 in different number of mutual funds. Consider the following scenarios:
- You invest in only one equity fund. Over the next one year, the fund performs badly and has gone down by 20%; the market value of your holdings will go down to Rs. 24,000. By investing in a single fund, you have increased your risk profile considerably which has resulted in a huge wipe-out of your investment.
- You divide this amount equally and invest in two equity funds - a large cap and a mid cap fund. After a year, the mid cap fund falls by 20%, whereas the large cap fund gives a positive return of 25%. The market value of your holdings will be Rs. 30,750. Though you have not diversified asset classes, you have invested in different categories of mutual funds. Your gains in the large cap fund has offset the losses in the mid cap fund.
- You invest 50% in a diversified equity fund and another 50% in a debt fund. After a year, the equity markets have performed badly and your investment in the equity fund has fallen by 20%. However, the debt markets have been in good shape and your initial investment of Rs. 15,000 has grown by 20%. The market value of your holdings will be Rs. 30,000. You have invested in different asset classes, thus helping you diversify risk at asset class level. As in Scenario 2, you have again at least preserved your initial capital.
Though all the return percentages in the above illustration have been assumed, it is suffice to show that spreading your investment across funds and asset classes will help you reduce risk.
Adding mutual funds in the same category - Is it beneficial?
The portfolio of similar categories of mutual funds will almost be the same, with investments being made in mostly the same set of companies. For instance, if you invest in a large cap diversified equity fund, your money will be invested in the best 30-40 large cap stocks in this category. Now when you invest in another mutual fund of the same category, your money will be invested in almost the same set of stocks as the first investment, except maybe for a few changes.
Let’s take the case of sectoral funds. Two funds investing in the same sector may invest in different companies. But sector-wise movements will be similar, giving similar results to the investor. Same is the case with any other category of mutual fund. Beyond a certain point, neither is the risk reduced, nor are the returns enhanced. So adding more mutual funds of the same category is not advisable.
How much is too much?
It is often said that if you begin to forget the names of the mutual funds you hold, it is time for you to bring down the number of funds in your portfolio. It is recommended to invest in a maximum of 4-6 good quality funds across debt and equity asset classes in various categories, with regular review of performance. Ideally your portfolio should have a good mix of the best large cap, mid cap and sectoral funds in the equity category along with a couple of funds in the debt category. Since most of the investors under invest in Equity, should you invest in a Debt Fund? Should you give 5 to10% weight to Sector Funds and Gold ETFs? These are the questions that need overall review of your Personal Finances, Your Financial Goals and overall investment priority. Please click here to download our sample financial plan for you to get an overall view of how such decisions should be taken.
Investing in few funds aids in better tracking, helping you get rid of funds where you may be losing money and also reduces transaction costs. So next time you think of investing in a fund, remember to check what value-add it brings to your portfolio before purchasing it.
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