Mutual funds are pooled investment funds where you outsource the investing to a fund manager. There are active and passive mutual funds. ETFs and mutual funds are good vehicles for retail investors, especially those who aren't equipped to pick individual stocks. Many investors wonder how many mutual funds they should have in their portfolio. Is there really a magic number?
Diversification across asset classes and categories
You can achieve diversification across asset classes and categories through mutual funds. For example, you can invest in equities—U.S. and international, fixed income, commodities, and real estate. Diversification is one of the basic rules of investing. Like the saying goes "don’t put all your eggs in one basket."
When it comes to mutual funds, you should diversify at three levels, which would eventually determine the ideal number of mutual funds you should have in your portfolio. First, you should have mutual funds across asset classes. Prudent asset allocation entails diversifying your money across equity, debt, commodities, and real estate. However, the percentage of the money you put in an asset class would differ according to your risk profile. Investors who can bear higher risk should put more money into equity mutual funds.
Second, you should diversify your mutual funds within the asset category. For example, if you are investing in equity mutual funds, you should spread it across large-cap, mid-cap, small-cap, and international funds. You can also take sectoral bets by investing in sector-specific funds. There are mutual funds that only invest in technology stocks. Tech stocks have soared to record highs this year. They are the S&P 500's best performing subsector this year.
Finally, you should spread your investments across different mutual fund managers. There isn't a set definition of how many mutual fund managers you should invest with. Ideally, you should split your mutual funds over at least three different fund houses.
How many mutual funds should you hold?
Different financial advisors would have a different answer about how many mutual funds should you hold in your portfolio. Ideally, you should not have more than 20 percent of your funds in a single mutual fund. In terms of the number of mutual funds, you should strive to keep it below 10. There isn't a problem necessarily with having more schemes in your portfolio, but it could lead to overlap. The mutual funds might be holding similar schemes in their portfolios.
By having too many schemes, you could end up over diversifying your portfolio. Finally, it would be cumbersome from an operational standpoint to keep track of so many schemes. While you entrust the fund manager with your investments in mutual funds, you should still regularly follow the performance and prune out funds with consistent underperformance. For your tax filings, you would have to maintain a record of all the mutual fund schemes.
Finally, you should remember that diversification through mutual funds is a good investment strategy. However, like most other good things, it can be counterproductive if it's done in excess. You can have ample diversification with a few mutual fund schemes. More schemes may or may not bring diversification, but it would mean spending more time tracking your funds.