Mutual funds have found a way to be part of every person’s portfolio since their launch in the Indian investment market. There are many types of mutual funds that are available in the market and can be tailored for every individual to suit their needs. The returns generated by mutual funds are quite higher than the traditional investment options like fixed deposits, Government Bonds, etc. This makes it an attractive investment option for every class of investors whether they have high risk appetite or low.
However, there are many cases where the investors go overboard and have overloaded their portfolios with too many funds. This does not always result in higher returns but may ultimately become cumbersome for the investor to manage the funds as well as increase the overall cost of investment.
Meaning of diversified portfolio
A diversified portfolio is a portfolio where the investor has a good variety of funds in their kitty. These funds usually have different underlying investments or assets. So the investor has the benefit of hedging against market volatility. If one of the funds is underperforming and the other is doing good, the investor will be able to ride out the volatility and may still end up in the green.
Benefits of diversification
Diversification is one of the prime benefits of investing in mutual funds. Investors can get many benefits of diversification in mutual funds. Some of such benefits are highlighted below.
- Manage the risk
One of the key benefits of diversification is the ability to manage the risk of investment in the markets. This risk is high or low depending on the underlying assets of the fund and other relevant factors like fund manager expertise, entry or exit from the market, etc. Having a diversified portfolio allows the investor to reduce the overall risk of the portfolio.
- Get maximum returns
A diversified portfolio also helps the investors maximize their profits. If the investor invests all their savings in a single investment product, the risk of losing it all is extremely high at the same time the returns are limited. A diversified portfolio will benefit the investor in getting higher returns on the portfolio.
- Access to different asset classes and sectors
Another benefit of diversification is access to multiple sectors or classes of investments. This allows the investors to get the benefit of volatility from different industries or sectors. Therefore, if one sector is performing better than the other, investors can get the benefit of higher returns from such sectors.
When is a portfolio over diversified?
With the multiple benefits of diversification, it is not unusual for investors to cross the fine line between diversification and over-diversification. Over-diversification is when the investor has too many mutual funds of the same category or has funds that have similar underlying securities. Such over-diversification will not provide the usual benefits of diversification but will rather erode the returns and pile up on the cost of investment.
There are a few ways that investors can identify an over-diversified portfolio. Some of such ways are discussed here.
- Excessive impact of a single event
The classic example of an over-diversified portfolio is when a single event causes a huge impact on the entire portfolio. Such events can be economic, political, or a change in the policies or guidelines of the SEBI, etc.
- Too many funds of the same category or funds having similar underlying investment
A portfolio having too many mutual funds of the same category will react strongly to any change relevant to the underlying securities. When the investor invests in too many funds from the same category (such all equity mutual funds without having any element of debt funds) in the name of diversification, the result is an over-diversified fund. Investors should pick the category of funds they wish to invest in and limit their investment in such a category to include other such categories in their portfolio.
What are the limitations of over-diversification?
We have established that over-diversification is not suitable to maintain a healthy portfolio. The perils of having an over-diversified portfolio are discussed hereunder.
- Excessive costs
By over-diversifying the portfolio, one of the most obvious disadvantages that the investors will face is the increased cost of investment. The returns may not justify the overall cost of investment. With each extra investment in the portfolio, the investor will add to the costs like expense ratio, brokerage fees, etc.
- Difficulty to track the funds
Another disadvantage of an over-diversified fund is the difficulty in tracking the investments. Investors will have to keep a track of all the investments in the portfolio to ensure that they can take the correct decisions to enter or exit the market to stay profitable.
What are the things to consider while creating an investment portfolio?
In order to ensure that the portfolio stays healthy or profitable, the investors are required to carefully select their investment. They can also take the help of investment advisors to manage their portfolios. Investors can consider the following steps to ensure that they are creating a sound portfolio.
- Select the fund category
The first step in creating a portfolio is to select the fund category that the investor wants to invest in. There are several options for the investors to choose from at this point like debt funds, equity funds, hybrid funds, ELSS funds, etc. As this is the starting point of making an investment, it needs careful analysis and understanding on part of the investor.
- Select the top funds in the category
The next step is to select the right funds in the category selected above. The factors that are involved in selecting the right funds can be the risk appetite of the investor, returns expectations of the investor, the cost of investment, investment objective, etc.You could also pay attention to certain technical factors like Alpha & Beta generated by the funds, if you have the appetite to do so. Or you could invest through Finity which takes all the trouble of selecting the right mutual funds for you based on your risk level and investment needs.
- Ensure that the funds do not have the same underlying assets
Investors should also take care to ensure that they do not have overlapping assets in their funds selected from the required categories. These funds should have majorly different assets so they can get the right benefit of diversification.
- Do not go overboard
While having good funds to invest in is essential, it is also important that the investor knows when to restrain themselves. Over-diversification will turn the portfolio unfavourable in the long run and will simply be cumbersome and expensive for the investor.
Mutual fund investments have the potential to increase the investor’s wealth multifold. But the investors have to also ensure that they have a good balance between the correct number of investments in their portfolio. ‘Not too much and not too less’ should be the motto while forming a portfolio. Most experts believe that having more than 6-8 mutual funds in a portfolio is excessive and is in the line of over-diversification of the mutual funds.
1. What is the ideal number of mutual funds that can be part of a portfolio?
There is no definite or ideal number of funds in a portfolio. However, according to many experts, having 6-8 funds inclusive of different categories is ideal for an average investor.
2. Should equity funds always be part of the portfolio?
Equity funds have the maximum potential to outperform the markets in the long run and generate maximum returns. Hence, it is advisable to have at least large cap funds in the portfolio representing equity funds even for risk averse investors. But again, it all depends upon your investment objective and risk tolerance.
3. What is the impact on investment cost due to over-diversification?
The cost of investment increases significantly on account of the over-diversification of the portfolio.
4. Can a person achieve higher returns due to over-diversification?
No. The increased cost of investments may erode the portfolio returns and hence, over-diversification may not always result in higher returns for the investor.