Ever heard of the saying ‘Don’t put your eggs in one basket? It basically means diversifying your investments to reduce the risk of investing. But mutual funds already invest in multiple stocks, so isn’t one mutual fund enough to spread your risk? Well, the answer is no. One mutual fund has a little bit of everything but not enough of anything. Hence investing in one mutual fund is not enough. This might lead you to the question, ‘how many mutual funds should I have in my portfolio?’ Read to find out the answer to this and how to build a mutual fund portfolio.
Diversification of Mutual Funds
Diversification is a risk management strategy wherein you spread your investments across multiple asset classes to reduce the portfolio’s overall risk. The idea behind diversification is that the risk of an individual security is reduced, and the portfolio will give higher returns in the long term.
So basically, the underperformance of an asset is negated by the good performance of other assets, and the overall portfolio returns will be maintained in the short term. Diversification doesn’t eliminate the market risk, but it tends to reduce it by making your portfolio strong enough to face market volatility.
Diversification is very important when investing in mutual funds. This is because the markets are not stable. Instability in the markets can lead to fluctuations in your portfolio as well.
If one fund isn’t performing well, it doesn’t mean others do too. Diversification works well in mutual funds only if you spread your investments across asset classes and investment styles. This means investing in equity, debt, or gold funds and also ensuring you diversify within the asset class. Take, for example, equity funds. Invest in large, small, and mid-cap, or value and growth funds to reduce your risk of investing in equity.
However, you have to be careful when diversifying. The major risk of diversification is over-diversification. Investing in too many mutual funds can actually harm your portfolio than do you good.
Disadvantages of Diversification
Over-diversification is simply diversifying too much. It happens when each additional asset added to the portfolio reduces overall return greater than risk reduction. In other words, when you over-diversify, you are not benefitting from that additional asset. Instead, you are increasing the portfolio’s risk.
The following are the risks of over-diversification:
- Overall returns are affected: The overall portfolio returns are lower than you expected, mainly because the incremental asset is not adding value to the portfolio. In fact, it is harming the portfolio. Moreover, the purpose of diversification is lost, which is risk reduction.
- Higher expenses: By investing in multiple funds, you are incurring higher expenses. The overall cost increases, ultimately leading to lower returns.
- Difficult to monitor: The more the number of funds, the more difficult it is to monitor your portfolio. You have to keep track of all the funds and ensure they are performing well. The more the number of funds, the longer it takes to monitor your portfolio. This might ultimately discourage you from monitoring your portfolio, which might harm your portfolio.
What is the 12-20-80 (baara, bees, aur assi) rule?
Quantum Mutual Fund has introduced the 12-20-80 rule for asset allocation. Using this strategy, you can build a balanced portfolio to earn wealth in the long term and reduce downside volatility in the short term.
- 12 months – Liquid fund: An emergency can knock on your door anytime. Hence it is important that you have a backup plan for such situations. Park at least 12 months of expenses in a liquid fund. This fund can be used to pay for bills, or expenses, during emergencies.
- 20% – Invest 20% of your portfolio in gold. This will help you create a hedge against market volatility and inflation. Historically, gold always outperformed well when the markets underperformed, and vice versa. Hence investing 20% in gold will help balance the risk in your portfolio. Invest in gold ETFs or bonds, as they are very liquid and are safer than physical gold.
- 80% – Invest 80% of your portfolio in equities to create wealth in the long term. Within equities, makes sure you invest across funds with different market capitalization and investment styles. Every investment should be unique so that it will add value to the portfolio and not endanger it. Within equity, you can diversify by investing 70% in the fund of funds that are very diversified. Out of the rest, 15% can go into a value fund which will help the fund earn risk-adjusted returns in volatile periods. The last 15% can go into an ESG fund concentrating on companies with good environmental, social and governance practices.
Things to keep in mind while building a mutual fund portfolio
There is no right way to build a mutual fund portfolio. This is because every investor is unique and what suits one investor might not suit the other. Hence you shouldn’t run behind top funds just because everyone is investing in them. Instead, you should invest in funds based on your goals and resources. Following are some pointers to keep in mind while building a mutual fund portfolio.
- Consider your objectives: Make a list of all your financial goals and arrange them based on priority. A goal can be anything that requires money. For example, buying a watch, going on a vacation, or early retirement. For goals that are to be achieved within three years, liquid funds or short-term debt funds are the best. Invest in equity funds for any goal with a duration of more than three years. This is because equity has the potential to give good returns in the long run.
- Ignore funds with a high expense ratio: Mutual funds charge a fee from investors. This fee varies from fund to fund. A high fee can reduce your return in the long run. Hence ignore funds with a high expense ratio when selecting funds to invest.
- Diversify: Invest across asset classes. Invest in debt funds, equity funds, and gold funds. You can use the 12-20-80 rule for asset allocation. Make sure you don’t invest all your money in one asset class, as it increases the risk. You should also diversify within the asset class. For example, invest in different investment styles, such as value and growth across different market capitalizations. Finally, diversify across geographies. Consider investing in international or global funds, that is, funds that invest in shares of other companies. This will ensure that you are avoiding excess concentration in one market.
- Avoid overlap: When investing in mutual funds, ensure there is no overlap in the securities of the funds. This means checking the portfolio of each of the funds you invest in and ensuring that each portfolio is different. This will ensure proper diversification.
- Monitor: It is important that you monitor your portfolio regularly. Check whether all funds are performing well. If not, replace the underperforming ones with better funds. Do not keep adding funds to the portfolio because the existing ones are not performing well. Just replace the bad ones, so your portfolio’s performance is up to the mark. This way, you won’t over-diversify.
How many mutual funds should I own?
There are several types of mutual funds, and it is important that you invest across all categories to diversify correctly.
- Large cap mutual funds: They invest in companies that rank from 1 to 100 as per market capitalization. Ideally, you have to invest in only one large cap fund. Anything more will lead to overlap in securities. This is because the number of large cap companies is limited.
- Midcap mutual funds: You could invest in one or two midcap funds. Midcap stocks are the ones that rank between 101 and 250. The universe of midcap stocks is slightly bigger than large cap stocks, and the chances of overlap are less.
- Small cap mutual funds: You can invest in one of your two small cap funds based on your risk tolerance. There will be hardly any chance of overlap as the small cap universe is large. All companies beyond rank 250 are small cap companies.
- Sectoral funds: Sector funds invest in one specific sector. By investing in one sector fund, you are just investing in one sector. If you don’t understand the market and when each sector performs well, it is better to avoid sector funds altogether.
- Fixed-income or debt funds: You could invest one or two debt funds based on your goals. Ideally, 1-2 debt funds are enough. Park your emergency fund in liquid funds, and for goals within three years, you could choose short-term debt funds.
- Gold funds: Invest only in gold funds that invest in physical gold. Ideally, one gold fund is enough for your portfolio.
So, a total of 5-8 mutual funds are enough to ensure proper diversification. Anything more can lead to an overlap of securities and over-diversification.
It is rightly said, ‘Strength lies in differences, and not in similarities.’ But at the same time, it is important to not over diversify. Over-diversification can only give ordinary results. Strike a balance between risk and return by correctly spreading your investments across asset classes.