Are You Over Diversified? When Too Many Mutual Funds Can Backfire

Over Diversified

Diversification is traditionally promoted as being one of the golden rules of investing. By diversifying your investments across a range of asset classes, industries, or geographies, you reduce the chances of disastrous loss. Like every strategy, diversification also has its limit. When taken too far — more so in terms of mutual funds — it creates a condition of Over Diversified. This effect can dilute your profits, make it harder to hold your portfolio, and boost costs without proportionally decreasing risk.

Here in this article, we analyse why diversification can fail, how you might recognise that you are over-diversified, and how you can maximise your returns from your mutual fund portfolio.

The Logic Behind Diversification

Diversification seeks to minimize unsystematic risk — the risk of one security or one industry, by diversifying across many instruments. Mutual funds automatically provide diversification because each fund contains a portfolio of securities. They appeal to individual investors who do not have the capital to create a diversified portfolio for themselves.

But then it becomes complicated: most investors believe that more mutual funds mean more diversification. Not always.

The Flaw of Over Diversified

1. Diminishing Returns

Sitting in a few mutual funds in a portfolio decreases risk somewhat. But after that, returns taper off. Over Diversified spreads your investment so thinly that your winner funds or sectors make less to your total returns. Your winners are essentially diluted by sheer quantity of other stocks.

2. Overlapping Holdings

Mutual funds in the same fund category or even a different investment category tend to have numerous of the same holdings. For instance, if you have four large-cap stock funds, there is a strong likelihood that they all hold slices of some of the same blue-chip stocks. Rather than achieving further diversification, you can end up with more exposure to the very same assets, coupled with concentration risk and misleading yourself into thinking you are diversified.

3. Increased Costs

There are expense ratios, management fees, and even exit loads on all mutual funds. The cost is cumulative if you have too many funds. The more funds you own, the more transactions there will be, if you keep them hoping to rebalance the portfolio, resulting in extra tax charges and brokerage charges.

4. Complicated Portfolio Management

To have a portfolio of 8 to 12 mutual funds, as too commonly observed among individual investors, requires a lot of time and effort. Tracking performance, looking at holdings, knowing tax implications, and rebalancing the portfolio from time to time proves to be too much for most. Such complexity leads to investor lethargy and bad choices.

5. Portfolio Redundancy

All too often, money comes in on the back of recent good performance rather than any fundamental need. What you then have is a cluster of funds with the same goals, duplication without extra benefit. For example, to have five separate mid-cap funds and all five having done well last year may be useless to you in the long run.

How Many Mutual Funds Are Enough?

The ideal number of mutual funds would depend on your investment goals, tenure, and risk-taking capacity. Even otherwise:

• Equity Mutual Funds: 2-3 diversified schemes spanning alternate market capitals and sectors are sufficient for most investors. For example, one large-cap, one mid-cap or flexi-cap, and one sectoral or thematic scheme (optional) can provide considerable diversification.
• Debt Mutual Funds: 1 or 2 funds e.g., a short-duration debt fund, and a liquid fund can manage risk and serve liquidity needs for short-term.
• Hybrid Funds: If you want a one-stop solution, a balanced or aggressive hybrid fund could minimize the need to keep separate equity and debt funds.

Don’t think quantity but quality and strategic allocation.

Tips to Avoid Over Diversified

1. Know Your Investment Objectives

Each mutual fund you invest in your portfolio must serve a purpose. Long-term growth, income generation, or liquidity, each fund must serve a particular money objective.

2. Review Existing Holdings Before Investing In New Ones

Before investing in a new fund, see how much its holdings overlap with your existing funds. Most investment platforms and tools offer analytics that can assist you in reviewing overlap and sectoral exposure.

3. Don’t Follow the Herd

Don’t be a herd follower by investing at random in the “best-performing fund of the year.” Past performance is not indicative of future performance. Be consistent and don’t go for random diversification.

4. Consolidate When Convenient

If you have a bunch of funds with the same goal and comparable holdings, consider consolidating them. This simplifies monitoring and rebalancing and can save you money.

5. Rebalance Occasionally

An annual update of your portfolio should be adequate for most investors. In doing so, check performance, re-jig asset allocation, and shut outperformers or duplicative funds.

Is Your Portfolio Over Diversified?

Ask yourself:

• Do I own more than 6-7 mutual funds?

• Are there several funds out of the same group (i.e., three big-cap funds)?

• Do I understand what each fund in my portfolio is doing?

• Do I struggle to track performance or rebalance?

If you said “yes” to most of them, chances are you’re over-diversified.

Also, Check – The Impact of Overconfidence Bias on Investment Portfolios.

Final Thoughts

Diversification is a vital pillar of good investing. But, as with all things good, it becomes unpalatable if taken to excess. Over Diversified by using too many mutual funds not only can reduce your profits but also can make your investment experience unnecessarily complicated. Opt for a smaller, target-oriented, and research-based portfolio instead.

Sound investing is not about owning everything but about owning the right things in the right mix.

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Disclaimer – This article is for educational purposes only and does not intend to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the scheme-related document carefully before investing.