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Is Your Mutual Fund Portfolio Overdiversified?

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As a child you may have heard of the popular proverb “ too many cooks spoil the broth”. This holds true when it comes to your mutual fund portfolio as well. While financial pundits constantly harp on having a diversified portfolio to spread out your risks, it doesn’t take much for your portfolio to enter the over diversified zone. So how do you know your portfolio is diversified or has tipped towards over-diversification? what is the ideal number of funds to have? all this and more is covered in the post ahead. Read On!

Why Should You Diversify Your Portfolio? 

Before we talk about over-diversification, let’s brush up our basics around portfolio diversification. When it comes to building a mutual fund portfolio, the key to achieving your financial goals in a smooth manner is building a well-diversified portfolio. The purpose of diversification is to spread your investment risk across multiple investments so that an adverse movement in any one or two investments does not have a large impact on your portfolio returns.

However, diversification works well only if the investments in the portfolio are markedly different from each other ie. they are uncorrelated. Many investors have the misguided view that risk is proportionately reduced with each additional mutual fund investment in a portfolio, when in fact this couldn’t be farther from the truth.

There is strong evidence that you can only reduce your overall mutual fund portfolio risk to a certain point beyond which there is no further benefit from diversification. Optimal diversification is possible not by adding a large number of mutual funds to your portfolio but by adding a number of uncorrelated mutual funds to your portfolio.

How To Spot If Your Mutual Fund Portfolio Is Overdiversified 

Owning too many mutual funds within a single category –  when building a diversified mutual fund portfolio, the idea is to invest in different types of mutual funds such that you have multiple sources of returns and the overall risk of the portfolio is mitigated. However, if you have invested in multiple funds of the same category then it is most likely that your mutual fund portfolio is over-diversified.

Any single news flow or development has a disproportionate impact on your overall mutual fund portfolio – this is an important indicator of over-diversification. If despite investing in multiple mutual funds, a single news flow or macro-economic development can have a disproportionate impact on your overall mutual fund portfolio, then it is likely that your mutual fund portfolio is over-diversified.

How Many Funds Are Ideal For A Diversified Portfolio? 

This is one of the most common problems faced by investors who understand the importance of diversification. Unfortunately, there isn’t a magic number.  The optimal number of funds depends on multiple factors that include your investable amount, investment goals and risk profile. However, there are few things investors can consider in their quest to build the best diversified mutual fund portfolio.

  1. Determine the different categories, themes, and strategies of funds you want to invest in to create your mutual fund portfolio – you can spread your mutual fund investments cross-asset classes (debt/equity/hybrid), themes (sectoral) and strategy (dynamic/arbitrage), etc.
  2. Ensure that you do not buy more than 3-4 funds within each category – once you have determined the category, ensure that you do not have inordinately high exposure to any one category. However, this decision will have to be made after taking into consideration your financial plan and should reflect your risk/return profile.
  3. Ensure that you are diversified within a category as well – once the category has been determined, ensure that there is not a high amount of overlap within a category. For example: assume that you want to create a 40% exposure to equities.

Now, within equities, it would be advisable to invest in mutual funds across markets capitalizations and themes rather than invest in only one type, say
large-cap, of the mutual fund. For equity mutual funds, you can have around 3-5 funds in your mutual fund portfolio, which are spread across different market segments and fund management styles.

The Final Word

To sum up, it is extremely important to know that diversification is not a game of numbers but about investing across a range of companies, sectors and asset classes by using mutual funds as the instrument. Don’t add funds in your portfolio just because your friend suggested it to you or you saw it in the news that so and so the fund has been doing well and it would be a good idea to add it to your already loaded portfolio. Adding too many funds also increases the headache of tracking their performance which is an absolutely essential activity. First, monitor the performance of the existing funds in your portfolio. Only when you feel some of these funds are consistently giving poor results and weighing your portfolio down, should you choose to stop investing in them and select better funds in the same category. Overall, keep reviewing your portfolio periodically to ensure you are well on your way to achieve your financial objectives.

Happy Investing!

This article was published on groww.in and has merely been reproduced here.

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