Have you ever asked yourself how many mutual funds you should own ?
In an earlier article, we saw the rational behind how many stocks one should own. Let us check in a similar way, how many mutual funds one should have.
Whenever you think finance, think simple. Remember that complex financial products do not contribute to good financial planning in any way and the more you have of them in your portfolio, the messier it is.
As far as mutual funds are concerned, the number of mutual funds you should invest in is an important ingredient to the success of one’s portfolio.
How many mutual funds should you own?
When you put your money into a mutual fund, you are looking to diversify your risk and gain more returns. You want to diversify to reduce the risk of losing your money and you want to gain more returns to make your money multiply (and fly out to the Bahamas).
Basic diversification can be achieved by spreading your money into asset classes equity and debt. That makes a simple case of having minimum two mutual funds, one that puts your money into equity and another into debt.
Now within these asset classes, if you were to put your money in only one equity diversified mutual fund (or in only one debt oriented mutual fund), there is a risk that these asset classes could under perform over a period of time and cause a dent to your capital.
To exemplify, let us see some numbers as to what they could do to your investments.
Suppose you put in Rs 10,000 in X mutual fund (equity or debt, take your pick). If over one year, the mutual fund performance has gone down by 50% (imagine for a moment), the total market value of your holdings will be Rs 5,000. Now that is a huge blow.
As a basic risk management mechanism, you should spread your eggs into another basket and not put them in one. Suppose you chose to buy 2 mutual funds instead of one (2 equity or 2 debt) and you put in equal money into both. That makes it Rs 5,000/- each in X and Y mutual fund.
After a year, if X were to under former by 50% and Y were to outperform by 50% (continue imagining for a moment like you did about Bahamas), your total holdings will be Rs 2,500 in X mutual fund and Rs 7,500 in Y mutual fund – a total of Rs 10,000/-. You have at least preserved your capital by spreading your risk.
Compare this with the earlier scenario where you were left with just Rs 5,000 after a year of under performance of the only mutual fund you held.
Taking cue from this, it is safe to extrapolate that within equity and debt, one is wiser to have two mutual funds than just one.That takes our total to a minimum of 4 mutual funds one should own to reduce risk.
Of course, there is no limit to risk management you can do and one could extrapolate this figure to say that within equity, one could invest in largecap, midcap and small cap mutual funds and within debt, into long term and short term debt mutual funds. This extrapolation is correct but research has proved that the maximum number of mutual funds that is right for one’s portfolio is around 7-8. Beyond that, you can forget the Bahamas trip.
Let’s agree with the experts for a moment.
This is how the 7-8 mutual fund can be composed.
- Pick 2 large cap equity diversified mutual funds.
- Pick 2 mid cap equity diversified mutual funds.
- Pick 2 sectoral or thematic mutual funds.
- Pick 2 debt mutual funds.
Things to note
- It is not true that you need to necessarily have 7-8 mutual funds, please note that this is the maximum you should have.
- The number you pick depends on your goals, risk taking capacity and time horizon.
- You need to choose more equity mutual funds than debt because returns from equity are more than debt over a long period of time. This follows from the premise that you are investing in mutual funds to generate money for a long term goal.
- Choice of fund houses and the funds themselves should be done based on their performance and how expensive they are.
- Try and put at least 50% of your money into large cap equity funds. Large cap equity funds are safe in nature and should be your core portfolio. Putting in maximum money here ensures most of your money is safe.
- How much money to put in mid cap, small cap, sectoral funds and debt funds will be dependent on asset allocation of the investor.
- Avoid ramping up mutual funds in the guise of New Fund Offers.
- Look to sell out under performing funds every 1-2 years on a minimum.
- Before you add a mutual fund to your portfolio, check what value add it brings.
- If you begin to forget the name of the mutual funds you hold, its time you bring down the numbers.
- Keeping funds to a maximum of 7-8 allows you to manage them. The more funds you have, the more time you spend tracking them.
- More funds will not de-risk your portfolio more. Risk mitigation can be achieved with 7-8 mutual funds. Beyond that, its all noise.
- More mutual funds mean more churning eventually via buying and selling. This will lead to increase in costs for the investors.
Remember mutual funds are the best way to make money for small investors and should be leveraged through systematic investment planning.