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?
The idea of diversification is straightforward - Investing in different asset class, sectors and segments which perform differently at a particular point of time and reduces your overall risk. As it is said, "never put all your eggs in the same basket" does help describe the essence of diversification.
In simple terms, diversification is spreading risk across different assets class, including stocks, bonds, and cash. 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 you 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 parts of the world or even some financial parameter like different levels of interest cost or forex exposure. 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.
What if you put your eggs into different baskets but nearly all the baskets are same? That's not diversified!
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 you invest in just two, you may choose a multi-cap stock index fund and a bond index fund and achieve suitable diversification.
To be completely diversified, you can build a solid portfolio with five to seven mutual funds which could be
- Large Cap Fund
- Mid Cap Fund
- Small Cap Fund
- Foreign Fund Developed Market
- 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 the small-cap fund and can invest more in debt funds or vice-versa.
Also, given the right kind of funds, such as balanced funds, you can have a diversified portfolio with just one or two mutual funds. Therefore, right in the beginning, we said that the number of mutual funds you need in a portfolio depends on several factors.