The number of mutual funds you need in a portfolio depends upon several factors and to understand it better, you will first have to know about diversification and its need. What is diversification?
In simple terms, diversification is spreading risk across different asset classes, including stocks, bonds, real estate, cash and many more. Mutual funds make it easy to do this, let us understand how.
How can you get diversification through mutual funds?
Diversification is one of the many advantages of investing in mutual funds as you can invest as low as Rs.1000 (lump sum) in one fund and obtain instant access to a diversified portfolio. Whereas, if you want diversification in your overall portfolio without mutual funds then you might have to invest in various individual securities which will expose you to more risk and will comparatively require more money to invest.
A mutual fund allows for diversification between different sectors, different investment styles, different geographical locations, or even some financial parameters, such as different levels of interest costs or foreign currency. Therefore you can either buy a mutual fund that is broadly diversified, or you can buy different mutual funds to create your own diversified portfolio. But the biggest mistake that investors make while diversifying their portfolio with mutual funds is that they spread their money among several different mutual funds who are at the end similar to each other and have a high correlation. Therefore, they perform similarly under a given market scenario, i.e. during downturns they all tend to give similar negative returns, thus defeating the purpose of diversification.
How many Mutual funds do you need for diversification?
The number of mutual funds you need in a portfolio for maximum diversification benefits depends on several key factors. While it is possible to invest in just one fund and be diversified, you'll need at least two but probably no more than 10 to be fully diversified. If someone chooses to invest in just two, he may choose a multi-cap stock index fund and a bond index fund and achieve suitable diversification.
To be completely diversified, one can build a solid portfolio with five to seven mutual funds
which could be
1. Large Cap Fund
2. Mid Cap Fund
3. Small Cap Fund
4. Foreign Fund Developed Market
5. Debt Mutual Fund
The investment weightage in each fund is completely dependent on the investor's risk appetite and financial goals. A risk-averse investor can completely avoid higher risk investments, such as small-cap funds and can invest more in debt funds or vice-versa.
Also, given the right kind of funds, such as balanced funds, a person can have a diversified portfolio with just one or two mutual funds. As mentioned at the beginning of this article, the number of mutual funds required for diversification depends on several factors - the investors risk appetite and return objectives being the most important of those.