Investing in mutual funds and diversifying the portfolio is a constantly fed advice, but continuing with your investments without planning for risks can affect your short-term and long-term financial goals. You might unintentionally accumulate funds that become hard to manage and put your portfolio at risk.
Diversification is important for mutual fund investments, but how much is too much? Let’s get your questions answered.
Why do you need to declutter your portfolio?
- Over-diversification dilutes your returns
Imagine you have two investment portfolios, both at a valuation of Rs. 15 lakh. Portfolio A contains 6 funds, while Portfolio B is a mix of 25 funds, evenly distributed. Picture one exceptional scheme in each portfolio delivering an impressive 18% annual return while the remaining funds provide a consistent 10% annualised return.
Portfolio A, having fewer funds, exhibits a notably higher cumulative value because it holds fewer funds compared to Portfolio B which holds 25 funds. This scenario shows the impact of strategic fund selection, emphasising the effects of over-dilution in an excessively diversified portfolio.
2. Too many funds lead to decrease in returns
Investing in numerous funds might inadvertently lead to more stocks in your portfolio, diminishing the benefits of active investing and making your returns low. While your expense ratio remains high due to the active management of many funds.
3. Managing your portfolio becomes difficult
Tracking the performance of individual funds becomes increasingly challenging as the number of funds in your portfolio grows. Simplifying your portfolio can streamline these processes and provide a clearer picture of your investments.
What is the ideal number of mutual funds in a portfolio?
The opinions vary, ranging from a fixed number like 4-5 to broader ranges like 6–12. Yet, there is no sacred rule about this ideal number. While having a few funds makes sense for small investments, the same might not apply to larger portfolios.
Over-diversification in equity funds may not yield substantial benefits, but a slightly diversified approach with debt funds can provide higher returns. Optimal portfolio composition often hovers around 8 funds (+/-2), depending upon the investor’s financial goals and objectives.
How do you achieve the optimal number of funds in your portfolio?
Now that the drawbacks of an excessively diversified portfolio are clear, let us explore strategies to declutter your mutual fund holdings.
- List down your financial goals
The primary goal of investing and building a strong portfolio is achieving financial security and freedom. The first step in your portfolio decluttering should be to revisit these goals and check whether your investments align with your short-term and long-term financial goals.
These financial goals could include higher education, buying a car or home, or collecting corpus for marriage. Having a list of your expectations helps you eliminate funds that don’t support your dreams and make better financial decisions.
- Exit equity funds if they are underperforming consistently
If an equity fund has consistently lagged for a couple of years in comparison to its peer group, consider reallocating your investments to one with better returns. Keep in mind that equity funds are typically held for the long haul, so weigh this factor before making any changes. While taxes may be a concern, the opportunity loss from sticking with a poor-performing fund often outweighs potential tax savings.
- Opt out of sectoral or thematic funds
The short-term returns of sectoral/ thematic funds might have taken up space in your portfolio. However, these funds overburden your portfolio and can be volatile, lacking the diversification offered by broader funds that allow diversified segments of investible stocks. Regular diversified funds often provide exposure to appealing sectors/themes while offering greater stability.
- Revisit your need for mid- or small-cap funds
Evaluate the risk and return profile of mid/small-cap funds in your portfolio. If you’re not comfortable with extra risk, consider exiting these funds or ensuring they don’t dominate more than 30% of your portfolio.
- Review large-cap fund investments
It’s important to reassess your investment in large-cap funds, taking into account your individual risk profile, as this may vary for each person. Unless there’s a particular reason for having them in your portfolio, think about moving away from large-cap funds and opting for more versatile options like flexi-cap funds, which have the flexibility to invest across companies of various sizes. If you still want exposure to large-cap stocks, consider limiting your portfolio to no more than two index funds.
- Balance your debt allocation
Debt funds add a fixed-income component to your portfolio. If your portfolio includes multiple debt funds without a clear rationale, it might be time to reevaluate your fixed-income allocation. Ensure that your debt holdings align with your overall asset allocation strategy.
- Evaluate hybrid fund investments
If you have invested in hybrid funds, a blend of equity and debt investments, without a specific purpose, reconsider their role in your portfolio. Assess whether the automatic asset allocation provided by hybrid funds aligns with your investment goals, especially when your portfolio already contains equity and debt funds.
- Remove the overlaps
It’s beneficial to have a suitable category for each investment to avoid having too many common stocks in your portfolio. Simplify your portfolio by ensuring each category is distinct. This approach will help you avoid redundancy and streamline your investment strategy.
In the end, it all comes down to keeping it simple. Investing in too many funds may complicate your investment journey and work against the goal of good monetary outcomes. These suggestions help you reach an optimal number of mutual funds in your portfolio, but if you need an extra hand, it is wise to consult a professional.
