Diversification is one of the most critical principles of investing. The objective of diversification is to avoid concentration of any single investment or asset class in your portfolio, thereby reducing overall risk and optimally positioning your portfolio for long-term wealth creation.
Investing in diverse asset classes like Equity, Debt and Gold, which from a performance perspective, are not correlated to each other, can empower a smart investor to diversify his/her investments. The proportion of investments in respective asset classes should be a function of risk appetite and financial goals of the investor.
For example, an investor with a 5-year investment horizon and a moderate risk profile can consider allocating 30% to equity investments, 60% to fixed income assets and 10% to gold. The equity allocation shall enable long-term wealth creation, fixed income allocation shall enable stable and consistent returns, and gold allocation shall act as an inflation and volatility hedge.
While diversification across asset classes is critical, it is also important to diversify within an asset class. As an example, if an investor invests directly in stocks, it is prudent for them to diversify across multiple stocks of different sectors and sizes so as to avoid concentration risk to their entire investment corpus in case certain stocks fail to deliver.
Taking the above example forward, out of the 30% equity allocation, investors may look at parking 24% in largecaps which are established businesses and thus more stable, and 4% and 2% can be allocated to mid and small-cap companies to position the portfolio for growth while at the same time optimising market risks.
Mutual funds have become increasingly popular and have established themselves as an investment product of choice for High Net Worth as well as retail investors. Mutual funds offer the professional expertise of the fund manager, are diversified instruments, transparent in terms of management and offer investors simple and seamless access to capital markets.
From a diversification standpoint, mutual funds invest in 40-70 stocks on average, which is already well diversified. It becomes crucial that investors select an appropriate number of Mutual Fund schemes. For example, if an investor invests in 8-10 equity mutual funds, there could be a reasonably high overlap in terms of underlying investments resulting in diversification which neither helps in reducing portfolio risk nor helps in enhancing returns.
Another big challenge is that it becomes increasingly difficult for investors to track and review each fund in the portfolio when there are a large number of funds. Conducting an annual review of your portfolio is crucial to ensure that you have the right set of funds in your portfolio to achieve your long-term financial objectives.
To de-clutter and simplify your portfolio while ensuring adequate diversification, you may consider the following measures. The first step is to accord meaningful weightage to the best-performing funds. Schemes should be evaluated on an individual level as well as should be compared with their peers periodically.
Schemes which are lagging in performance on a sustained basis should be evaluated and weeded out. Secondly, investors should try and avoid investing in too many schemes from the same Mutual Fund category.
Lastly, one can research and avoid investing in funds that have a major holding overlap with each other. Investors should conduct a periodic assessment of one’s own financial goals and risk appetite to determine the asset allocation strategy and rebalance/exit from mutual fund schemes, which are not in-line with the same. To make this process more disciplined and professional, investors may take the help of a financial advisor.
While there is no precise answer for the number of funds one should hold in a portfolio, 8 funds (+/-2) across asset classes may be considered optimal depending on the financial objectives and goals of the investor. Further, higher allocation of portfolio to the right fund is of crucial importance. There is nothing wrong in deviating from the said number; however, one’s decision should be well-informed after taking into consideration their holistic investment goals and objectives.
(The author, Virendra Somwanshi is the Head of Wealth Management, Capital Markets & NRI at Bank of Baroda. Views are personal)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
FAQs
How many funds are enough? One thing you should always remember is that a lot of funds in your portfolio doesn't mean you have a diversified portfolio. A portfolio with 15 funds that have overlapping is not diversified. You should have no more than 4 funds in your portfolio.
What is the ideal number of mutual funds in a portfolio? ›
How many funds are enough? One thing you should always remember is that a lot of funds in your portfolio doesn't mean you have a diversified portfolio. A portfolio with 15 funds that have overlapping is not diversified. You should have no more than 4 funds in your portfolio.
How many different mutual funds should I have in my portfolio? ›
While there is no precise answer for the number of funds one should hold in a portfolio, 8 funds (+/-2) across asset classes may be considered optimal depending on the financial objectives and goals of the investor. Further, higher allocation of portfolio to the right fund is of crucial importance.
How many funds should you hold in a portfolio? ›
You should therefore only keep as many funds in your portfolio as you're comfortable monitoring. For example, if you hold 10 or 20 different funds, you'll need to keep a close eye on the changing value of all these investments to make sure your asset allocation still matches your investment goals.
What is the optimal number of assets in a portfolio? ›
As a result, investors will want a limit of how many assets to include in their portfolio to gain the optimal level of reduced risk while simultaneously reducing excess trading costs. Most industry professionals estimate a number of assets ranging from 20-30 in a portfolio to reduce the market risk.
Is it good to have 4 mutual funds? ›
The Downside of Diversification
While mutual funds are popular and attractive investments because they provide exposure to a number of stocks in a single investment vehicle, too much of a good thing can be a bad idea. The addition of too many funds simply creates an expensive index fund.
Is the 3 fund portfolio good enough? ›
While the three-fund portfolio is great because it's simple to learn and easy to manage, it isn't without its disadvantages, as we discuss on our personal finance primer.
Is it wise to have multiple mutual funds? ›
Investing in multiple mutual funds can be a smart move for investors who want to diversify their portfolios and gain access to professional asset management. However, it's important to be aware of the possible drawbacks, such as the potential for over-diversification and higher transaction costs.
What is the ideal investment ratio? ›
“Ideally, you'll invest somewhere around 15%–25% of your post-tax income,” says Mark Henry, founder and CEO at Alloy Wealth Management. “If you need to start smaller and work your way up to that goal, that's fine. The important part is that you actually start.”
What is the ideal investment portfolio? ›
A good way to minimize risk is by creating a diversified and balanced portfolio with stocks, bonds, and cash that aligns with your short- and long-term goals. From there, you can broaden your portfolio to include other assets like real estate or high-risk investments for an increased likelihood of higher returns.
You should put no more than 10% of your total net assets in high-risk investments, with the remainder diversified across a range of mainstream investments. Read our article about how diversification can work for your investments.
What is the 5% portfolio rule? ›
This rule suggests that investors should not allocate more than 5% of their portfolio in any one stock or investment. The idea behind this rule is to limit the potential risk to the overall portfolio if one investment does not perform as expected.
What makes a portfolio optimal? ›
Portfolio optimization is a process in which an investor chooses their assets to optimize on one or more specific objectives. Typically, these objectives include minimizing financial risk and maximizing financial return — the perpetual tightrope walk with which every investor has become familiar.
How to find the optimal portfolio? ›
The optimal risky portfolio is found at the point where the CAL is tangent to the efficient frontier. This asset weight combination gives the best risk-to-reward ratio, as it has the highest slope for CAL.
What is the 75 5 10 rule for mutual funds? ›
Diversified management investment companies have assets that fall within the 75-5-10 rule. A 75-5-10 diversified management investment company will have 75% of its assets in other issuers and cash, no more than 5% of assets in any one company, and no more than 10% ownership of any company's outstanding voting stock.
What is the 15 15 rule of mutual funds? ›
Meaning of the 15-15-15 rule in Mutual Funds
The Investment: You should invest Rs 15,000 per month. The Tenure: The total of your investment should be 15 years. It means that you will invest Rs 15,000 every month for the next 15 years. The Return: Your expected returns on your investment should be 15%
What is the 4% rule for mutual funds? ›
Say an investor has retired with a $1 million portfolio. In her first year of retirement, under the 4% rule, she should withdraw 4% of that portfolio, or $40,000 ($1 million x 0.04). For each subsequent year, she should adjust the withdrawal amount for inflation.
What is the 80% rule for mutual funds? ›
The Names Rule currently requires registered investment companies whose names suggest a focus in a particular type of investment to adopt a policy to invest at least 80 percent of the value of their assets in those investments (an “80 percent investment policy”).
