Mutual Fund Strategies: Diversifying Your Portfolio With Multiple Funds

Investing in mutual funds is a popular choice for those looking to diversify their portfolios and limit their risk of potential investment losses. While diversification is a sound strategy, it is possible to overdo it and end up with a portfolio that underperforms. So, how many mutual funds should you invest in?

The answer depends on several factors, including your investment goals, risk tolerance, and time horizon. Generally, a well-balanced portfolio with 20-30 stocks is considered diverse enough to mitigate the maximum amount of unsystematic risk. However, a single mutual fund often contains a much larger number of stocks, so investing in multiple mutual funds may not always be necessary or beneficial.

Holding too many funds can dilute returns, as the gains from high-performing schemes may be cancelled out by losses from low-performing ones. It can also make your portfolio more challenging to monitor and review effectively.

Therefore, it is essential to focus on choosing the right types of mutual funds and ensuring they do not hold the same underlying stocks, which would defeat the purpose of diversification.

While there is no one-size-fits-all answer, a good rule of thumb is to hold a limited number of funds, such as 3-4 equity funds and 1-2 debt funds, and regularly rebalance your portfolio to weed out any underperforming funds.

Diversification and risk mitigation

Diversification:

Diversification is a risk management strategy that involves spreading your investments across various assets, industries, or investment types to reduce the impact of any single negative event. By diversifying your portfolio, you can reduce the risk of losing a significant portion of your investment if one company or industry underperforms.

When deciding how to diversify your portfolio, it is important to understand the difference between asset classes and asset categories. Asset classes refer to broad categories of investments, such as stocks, bonds, and cash. On the other hand, asset categories refer to more specific types of investments within each asset class, such as industries and companies within the stock asset class.

To achieve effective diversification, you should aim for a mix of asset classes and asset categories that align with your investment goals and risk tolerance. For example, if you are investing for capital appreciation, you may want to allocate more of your portfolio to stocks, while those seeking a steady income may prefer a larger allocation of bonds.

Risk Mitigation:

Investing in multiple mutual funds can be a way to mitigate risk by diversifying your portfolio. However, it is important to note that simply investing in multiple funds is not enough. You also need to consider the underlying holdings of each fund to ensure true diversification.

One common mistake investors make is assuming that holding multiple mutual funds automatically diversifies their portfolio. However, if those funds have similar holdings or focus on the same industry or asset class, your portfolio may not be adequately diversified. This is known as fund overlap, and it can negate the benefits of diversification.

To avoid fund overlap, carefully review the underlying holdings of the mutual funds you are considering. Look for funds with different investment objectives and holdings in different asset categories. For example, you could consider a mix of large-cap, small-cap, and international stock funds, along with bond funds, to achieve diversification across various industries and asset classes.

Additionally, the number of mutual funds you hold is not as important as the diversification and risk mitigation they provide. While some investors may prefer a simpler portfolio with fewer funds, others may opt for a more complex portfolio with more funds to increase diversification. Ultimately, the right number of funds depends on your investment goals, risk tolerance, and the amount of administrative work you are willing to undertake.

In summary, diversification and risk mitigation are crucial when investing in mutual funds. To achieve these, focus on diversifying across asset classes and asset categories, carefully review the underlying holdings of each fund to avoid overlap, and consider your investment goals and risk tolerance when determining the number of funds to hold.

The number of mutual funds for optimal returns

Optimal returns from mutual funds are dependent on a few factors, and the number of funds is one of the key considerations. Diversification is a common strategy to spread risk and optimise returns. However, it is possible to over-diversify, leading to lower returns.

The consensus is that a well-balanced portfolio should contain between 20 to 30 stocks to diversify away the maximum amount of unsystematic risk. A single mutual fund often contains five times that number of stocks, so one fund may be enough. However, this would depend on the type of fund and your investment goals.

For example, a broad index fund could be a single investment, but it would not provide exposure to international investments. So, for global coverage, you may need to add a large-cap domestic fund and a small-cap domestic fund, and one or two international funds. If you want fixed-income exposure, you could add a domestic bond fund, bringing the total to six funds.

Advantages of Multiple Mutual Funds

• Lower Risk: Multiple funds reduce the risk of loss from a single underperforming fund.
• Exposure to Multiple Sectors: Multiple funds allow investors to take advantage of market trends and opportunities across different sectors and industries.
• Professional Management: Multiple funds allow access to the expertise of different fund managers and their strategies.
• Customization: Multiple funds allow investors to customise their portfolio to meet specific investment goals and risk tolerance.
• Flexibility: Multiple funds provide flexibility to adjust the portfolio as investment objectives and risk tolerance evolve.
• Cost-Effectiveness: Multiple funds can be more cost-effective, providing exposure to a wide range of assets and sectors for lower fees than individual stocks or ETFs.

Disadvantages of Multiple Mutual Funds

• Over-Diversification: Too many funds can lead to lower returns as investments are spread too thinly.
• Higher Fees: Multiple funds may result in higher fees and expenses, which can eat into returns.
• Overlap: Multiple funds may lead to overlap in investments, increasing exposure to certain sectors or companies.

Number of Funds by Type

The number of funds will depend on the type of fund and your investment goals. Here are some guidelines:

• Large-Cap Mutual Funds: Up to 2 or 3. Beyond this, there will be significant overlap in shares owned.
• Mid-Cap Mutual Funds: Up to 2. These carry higher risk but offer higher returns potential.
• Small-Cap Mutual Funds: Up to 2. These are very risky and volatile.
• Debt Funds: Ideally 1, but 2 is also good. Returns are similar, so multiple funds are not necessary.
• Sectoral Mutual Funds: Invest in as many sectors as you have good knowledge about.

So, overall, 8 +/- 2 mutual funds seem like an ideal number, but this will depend on your specific circumstances and goals.

The impact of fund overlap

Fund overlap is when an investor holds too many mutual funds of a similar nature with the same core fundamentals. While investors may do this with the intention of diversifying their portfolio and reducing risk, it can often have the opposite effect. For example, if you divide your money equally between four different mutual funds, each representing 25% of your portfolio, and three of those funds are nearly identical, you won't get the diversification you need to spread risk.

When you hold too many funds with similar holdings, it dilutes returns. The losses and gains are cancelled out, and the profits from high-performing schemes are compromised by the losses from low-performing ones. If you hold too many funds, your portfolio may, in reality, act as a tracker fund, making it difficult to generate alpha if you end up owning the entire market. In this case, you may be better off investing in an index fund, which can save you money and protect you from the shock of underperformance.

Holding too many funds can also make your portfolio bloated and difficult to monitor. It may take up more time than is necessary, and you may not be inclined to review your portfolio regularly. This could lead to chronic underperformance going unnoticed and dragging down returns.

To avoid fund overlap, focus on choosing the right funds in the right proportion and regularly rebalancing your portfolio to identify and remove underperforming funds. When choosing funds, make sure they don't hold the same stocks, as overlapping will not provide the diversification you need.

While there is no magic number of funds to hold in your portfolio, three to four well-chosen funds are usually enough to make a well-rounded portfolio. To avoid overlap, analyse the funds' portfolios carefully and use online tools to determine the extent of any overlap.

The importance of asset allocation

Risk Mitigation

Firstly, effective asset allocation helps to mitigate risk. By diversifying your investments across different asset classes, such as stocks, bonds, and cash, you reduce the impact of losses in any one area of your portfolio. For example, if your portfolio is heavily weighted towards stocks and the stock market takes a tumble, you could lose a significant portion of your money. On the other hand, investing too much in low-risk, low-return assets like cash might mean your portfolio doesn't generate sufficient returns to meet your goals. A balanced approach, tailored to your risk tolerance and investment goals, is key.

Long-Term Growth

Asset allocation also plays a crucial role in long-term growth. Different asset classes perform differently over time, and by allocating your investments appropriately, you can maximise returns. For example, stocks (or equities) tend to offer the biggest returns over time but come with higher risk. On the other hand, bonds and other fixed-income investments provide a safer option with more modest returns. By allocating your assets effectively, you can ensure your portfolio has the right mix of risk and return to meet your investment objectives.

Diversification

Asset allocation is key to achieving true diversification. While diversification is often associated with investing in multiple mutual funds, it's important to understand that simply spreading your money across several funds is not enough. The underlying securities within those funds are what matters. If the funds you choose have similar holdings, you haven't truly diversified. To achieve effective diversification, you need to ensure your portfolio is diversified across asset classes (like stocks, bonds, and cash) and within asset categories (such as industries and companies). This ensures your portfolio isn't overly exposed to any one type of investment, reducing risk and optimising returns.

Regular Rebalancing

Finally, effective asset allocation requires regular rebalancing. Markets fluctuate, and over time, your carefully allocated portfolio can become unbalanced. For example, if one of your investments performs exceptionally well, it may come to dominate your portfolio, increasing your exposure to risk. Conversely, if an investment performs poorly, it may reduce your overall returns. By regularly reviewing and rebalancing your portfolio, you can ensure it stays aligned with your risk tolerance, investment goals, and the broader market.

In summary, the importance of asset allocation cannot be overstated when investing in mutual funds. It helps to mitigate risk, maximise long-term growth, achieve true diversification, and ensure your portfolio remains balanced over time. By allocating your assets effectively and reviewing your portfolio regularly, you can optimise returns while minimising risk.

Monitoring and reviewing your portfolio

• Regular Review: Conduct regular reviews of your portfolio, ideally at least annually. This allows you to identify any underperforming funds and make necessary adjustments. During your review, assess the performance of each fund and evaluate whether it aligns with your investment objectives.
• Performance Evaluation: Analyse the performance of your mutual funds by examining their returns over time. Compare these returns against relevant benchmarks and assess how they contribute to your overall investment goals.
• Risk Assessment: Evaluate the risk associated with each fund in your portfolio. Consider factors such as market volatility, fund type, and industry exposure. Ensure that the level of risk aligns with your risk tolerance and investment strategy.
• Diversification Check: Ensure that your portfolio remains adequately diversified across different asset classes, investment types, and industries. Diversification helps to mitigate risk and enhance long-term returns. Check for any overlap in holdings to avoid over-exposure to specific investments.
• Rebalancing: Periodically rebalance your portfolio to maintain your desired asset allocation. Over time, the performance of different funds can cause your portfolio to drift from its original allocation. By rebalancing, you buy or sell certain funds to return your portfolio to its intended composition.
• Fund Overlap: While diversification is important, be mindful of fund overlap, especially within the same asset class. Holding multiple funds with similar holdings may dilute your returns and negate the benefits of diversification.
• Expense Ratios: Keep an eye on the expense ratios of your mutual funds. Expenses can impact your overall returns, so consider the costs associated with each fund and assess whether there are opportunities to optimise expenses without sacrificing performance.
• Market Conditions: Stay informed about market conditions and trends. Monitor economic indicators, industry news, and market performance to assess how they may impact your portfolio. This will help you identify potential risks and opportunities for adjustment.
• Seek Expert Advice: Consult with financial advisors or experts to gain insights and guidance on your portfolio. They can provide valuable perspectives on market trends, fund performance, and strategies for optimisation.

By diligently monitoring and reviewing your portfolio, you can make informed decisions, stay on track with your investment goals, and maximise the potential for long-term returns.

Frequently asked questions