Smart Mutual Fund Investing: How to Diversify Without Overloading Your Portfolio

My friend invests in both the stock market and mutual funds, holding over 20 mutual funds. Managing such a large number of investments has become challenging, as he spends significant time tracking them. While diversification is important, this approach can lead to overlap, complexity, and higher costs. A better strategy would be to streamline the portfolio by focusing on fewer, well-researched funds and stocks that align with his goals.

It is generally not advisable to hold multiple mutual funds from different fund houses in the same category, such as several small-cap funds from ICICI Prudential, SBI, HSBC, HDFC, etc., in your portfolio. Here’s why:

1. Overlapping Holdings: Mutual funds in the same category (e.g., small-cap funds) tend to invest in similar stocks, as they are targeting the same market segment. This means that having multiple funds in the same category can result in overlapping holdings, which reduces the diversification benefit. Essentially, you are increasing your exposure to the same set of stocks, which can increase your risk without significantly improving returns.
2. Dilution of Potential Returns: By holding several small-cap funds, you might end up diluting the potential returns. Different funds might have slightly varying strategies, but in most cases, their performance will be closely correlated because they are all focused on the same sector (small-cap stocks). This can lead to an inefficiency where you’re not getting much more return for the extra exposure.
3. Increased Costs: Each mutual fund comes with its expense ratio, and by holding multiple funds, you might be increasing your total cost of investment without gaining significant diversification. Higher costs could eat into your returns over time.
4. Risk of Complexity: Managing a portfolio with multiple small-cap funds from different fund houses can make it harder to track your overall exposure to small-cap stocks. It can lead to excessive concentration in one asset class, which could expose you to more risk than you’re comfortable with.

Is it like buying different brands of televisions?
Just as owning multiple televisions from different brands doesn’t add value and might lead to wasted resources, owning multiple funds within the same category (e.g., small-cap funds) doesn’t meaningfully diversify or enhance your portfolio. The idea of purchasing 1-2 televisions after doing your research is like choosing 1-2 well-researched funds from a particular category, ensuring they fit your investment goals and risk tolerance. Once that part of your portfolio is aligned, the remaining funds can be directed toward different sectors or asset classes, allowing you to build a more diversified and balanced portfolio.

Recommended Strategy:

1. Limit to One Fund per Category: A more efficient approach is to limit yourself to one small-cap fund (or any other category) that aligns with your investment goals, risk tolerance, and fund performance. You can achieve diversification by choosing a fund with a well-rounded portfolio of stocks, or by adding other asset classes to your portfolio (like mid-cap or large-cap funds, or debt funds).

• Diversify Across Asset Classes: Instead of holding multiple funds of the same category, focus on diversifying across asset classes (equity, debt, international funds, etc.) and sectors. This will help spread risk and provide more balanced returns.

• In conclusion, as an investment expert, my advice would be to avoid holding multiple funds from different houses within the same category unless there’s a very specific reason. Stick to one well-researched and appropriately managed fund for each category and use other strategies to diversify your overall portfolio.

By doing so, you achieve several objectives:

1. Diversification Across Sectors/Asset Classes: Instead of concentrating too much in one area, you can diversify into other sectors or asset classes (like large-cap, mid-cap, or debt funds), which reduces the overall risk of your portfolio.
2. Efficient Use of Resources: Just like buying a second television when one or two are sufficient, investing in multiple funds from the same category can be inefficient. You can better use that money to invest in other sectors or diversify into other parts of the market, thus optimizing returns while minimizing risk.
3. Risk Reduction: By spreading your investments across different sectors, you reduce the chances of one sector or category negatively impacting your entire portfolio. This approach helps cushion against market volatility and ensures a more stable growth trajectory.

So, my expert opinion: do thorough research, pick the best fund(s) in one category, and once that part of the portfolio is in place, move on to other sectors or asset classes. This method ensures you reduce risk and increase the potential for returns through proper diversification.

Disclaimer.

Mutual Fund Schemes are not guaranteed or assured return products and the above article is not advice for investment but for study purposes. Investment in Mutual Fund Units involves investment risks, settlement risks, liquidity risks, and default risks including the possible loss of principal.