To protect your investments from unforeseen risks, every investment advisor will advise you to diversify them. But do you know you can overdo it?.
Investing in mutual funds is a popular way to diversify your portfolio and gain exposure to a wide range of assets. However with countless mutual funds available it’s natural to wonder how many is too many. This guide delves into the pros and cons of having multiple mutual funds, explores the concept of over-diversification, and provides insights on how to determine the optimal number of funds for your portfolio.
The Benefits of Multiple Mutual Funds
Diversification: Owning multiple mutual funds allows you to spread your investment across different asset classes, industries, and geographic regions This diversification helps mitigate risk and reduces the impact of any single asset or sector underperforming
Professional Management: Mutual funds offer the expertise of experienced fund managers who research, analyze, and select investments on your behalf This can be particularly beneficial for investors who lack the time or expertise to manage their own portfolios.
Liquidity: Mutual funds are generally highly liquid, meaning you can easily buy or sell shares when needed. This flexibility allows you to adjust your portfolio quickly in response to changing market conditions or personal circumstances.
Access to Niche Markets: Many mutual funds specialize in specific industries or sectors, providing investors access to niche markets that might otherwise be difficult to reach.
The Potential Drawbacks of Multiple Mutual Funds
Over-Diversification: While diversification is crucial, having too many mutual funds can lead to over-diversification. This can dilute your returns and make it challenging to track and manage your portfolio effectively.
Higher Fees: Each mutual fund comes with its own expense ratio, which can add up if you own multiple funds. These fees can eat into your returns over time, so it’s essential to consider the overall cost of ownership.
Redundancy: Some mutual funds may hold similar assets, leading to redundancy in your portfolio. This can reduce diversification benefits and hinder your returns.
Complexity: Managing a portfolio with numerous mutual funds can be complex and time-consuming. It requires careful monitoring and rebalancing to ensure your portfolio remains aligned with your investment goals.
Determining the Optimal Number of Mutual Funds
The ideal number of mutual funds for your portfolio depends on various factors, including your risk tolerance, investment goals, and financial situation. However, here are some general guidelines:
Large-Cap Mutual Funds: Limit yourself to 1-2 large-cap mutual funds, as they typically invest in the same large companies.
Mid-Cap Mutual Funds: Consider owning up to 2 mid-cap mutual funds, as they offer higher growth potential but also carry higher risk.
Small-Cap Mutual Funds: Due to their high volatility, restrict your small-cap mutual fund holdings to a maximum of 2.
Debt Mutual Funds: 1-2 debt mutual funds are sufficient, as they offer consistent returns with minimal risk.
Sectoral Mutual Funds: Invest in sectoral mutual funds only if you have in-depth knowledge of the specific sector.
Total: Aim for a total of 8-10 mutual funds, but adjust this number based on your individual circumstances.
Additional Tips for Managing Multiple Mutual Funds
Conduct thorough research: Before investing in any mutual fund, research its holdings, performance history, expense ratio, and management team.
Consider expense ratios: Choose funds with low expense ratios to maximize your returns.
Monitor and rebalance regularly: Regularly review your portfolio and rebalance as needed to maintain your desired asset allocation.
Seek professional advice: If you’re unsure about managing multiple mutual funds, consult a financial advisor for personalized guidance.
While having multiple mutual funds can offer diversification and professional management benefits, it’s crucial to avoid over-diversification and manage your portfolio effectively. By carefully selecting funds, monitoring your investments, and rebalancing regularly, you can optimize your portfolio and achieve your financial goals.
Over-Diversification of Mutual Funds
The aim of diversification is to spread risk. You run a lot of risk when you make excessive stock investments in one company.
A sizeable amount of your money might disappear if something were to happen to that company. In order to reduce that risk, you purchase stock in numerous companies.
Additionally, you purchase shares of businesses in various industries to further reduce risk. Thus, a sizable portion of your money will still be secure even if an entire industry is underperforming.
However, your investment won’t increase significantly if you invest in too many businesses and one of them succeeds greatly. The successful company would have had very little effect on your overall investment. Therefore, you should only own a small number of shares across most industries.
But is it really appropriate for you to use the same reasoning with your mutual funds? This is so because shares from a wide range of industries are purchased by equity mutual funds.
Usually, 50–100 shares are invested in equity mutual funds at any given time. Thus, you indirectly own shares of that many companies when you invest in an equity mutual fund. You already have a highly diversified portfolio! How Many Mutual Funds Should I Own?
Mutual funds are of many types.
Only large-cap company shares are invested in by large-cap equity mutual funds. Investing in many large cap mutual funds is not necessary. One well-chosen large cap mutual fund should be enough.
Mutual funds focused on mid-cap stocks are known as mid-cap equity funds. Comparing mid-cap companies to large-cap companies, the former grow at substantially faster rates. At the same time, the risk is also much higher.
It is possible for you to own a few mid-cap mutual funds after thorough research. Because there are many more mid-cap companies than there are shares, there is less likelihood of share ownership overlap in the case of mid cap mutual funds.
As the name implies, small cap mutual funds make investments in small cap companies. Due to their extreme volatility, small cap companies can experience both spectacular drops and sharp rises. Small cap mutual funds carry a very high risk.
When it comes to small cap mutual funds, the likelihood of share overlap is reduced. However, keep in mind that these mutual funds carry a high level of risk.
Invest in bonds and other market instruments with debt mutual funds. They are low risk, low returns mutual funds. The returns on debt mutual funds are fairly comparable over time and highly consistent.
Sectoral mutual funds allocate capital exclusively to specific sectors or industries. Investing in a sector mutual fund has nearly the same risk profile as purchasing shares in a single industry. To choose a mutual fund in any given sector, you should be well-versed in that sector.
So, How Many Mutual Funds Should You Invest in?
The answer to that, as usual, depends on you. As a general rule, unless you are extremely knowledgeable about mutual funds and the markets, you should own:
- Large Cap Mutual Funds: Up to 2. Maybe 3 at best. Beyond that, it makes no sense because the shares that your mutual funds own will greatly overlap with each other.
- Mid Cap Mutual Funds: Up to 2. Even though the returns could be higher, there’s a greater risk involved.
- Small Cap Mutual Funds: Up to 2. It is best to stick to a small number of small cap mutual funds because of how risky these mutual funds are. Additionally, stay away from investing a sizable portion of your mutual fund portfolio in small-cap mutual funds.
- Debt Funds: Ideally 1, but 2 is also good. It doesn’t make sense for you to own multiple debt mutual funds because the majority of them offer returns that are comparable.
- Sectoral Mutual Funds: You should invest in as many sector mutual funds as the number of industries you are extremely knowledgeable about. If you are not familiar with the industry that the mutual fund is investing in, you should avoid investing in these.
Approximately 8 (plus or minus 2) mutual funds appear to be the optimal quantity to possess. If you make a well-informed decision and choose to own substantially more or less mutual funds than what is recommended here, there is nothing wrong with it.
Should I Have Multiple Mutual Funds?
FAQ
Is it better to invest in multiple mutual funds or just one?
How many number of mutual funds should I have?
Is 5 mutual funds too many?
Are 10 mutual funds too many?
Should you invest in more than one mutual fund company?
Sometimes it can be wise to hold your investment assets at more than one mutual fund company or discount online brokerage firm . But should every investor spread assets among multiple financial firms or is the decision made on a case-by-case basis? What are some good reasons for investing in more than one mutual fund company?
Are mutual funds a good investment?
A few funds can be chosen that best fit an investor’s asset-allocation and risk-return requirements. 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.
How many mutual funds should you invest in?
Given that the average mutual fund is a basket of 36–1,000 stocks, you can technically achieve a diversified portfolio with only one fund. But investors who prefer greater diversification set the limit at eight. The right number of mutual funds for you depends on several factors, including your investment objective and tolerance for risk.
Are mutual funds better than individual stocks?
Mutual funds offer several advantages over individual stocks, including professional management, diversification, convenience, and accessibility. With mutual funds, investors can access a wide range of securities and assets managed by experienced professionals, reducing the risk and effort of selecting individual stocks.