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How many mutual funds to invest in for diversification? 3 critical things to keep in mind

The Financial Express logo The Financial Express 01-03-2019

A series of sharp falls and volatility in the stock markets, especially during the last year, served as a wake-up call for several investors. In such a scenario, a lot of investors turned to diversification as their go-to resort. Traditional wisdom says don?t put all your eggs in one basket. It restricts the damage to your financial well-being in case one asset class or instrument goes for a tailspin.

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Why do we diversify?

Diversification is to reduce the risk as well as to have the taste of other asset classes in different market conditions. When the rule is applied to investments, it means that you just won?t invest your entire money in a single asset class, say, equity mutual funds. You would spread your investments across different asset classes based on your risk profile and investment horizon so that you are not at the mercy of a single asset class.

Any diet needs to be a mix of carbohydrates, proteins, minerals, vitamins etc. Similarly, a financial portfolio needs to have different elements that play different parts. Therefore, in case you decide to diversify your funds across different fund houses, here are a few things you should keep in mind.

1. Identify your goal

Before you spread out your investments across funds, understand why you need to diversify. Your goals should define investment horizon, disposable income and the overall returns you are expecting. Moreover, you should gradually proceed towards adding funds in your portfolio ? if you diversify all at once, your portfolio will end up losing more returns.

2. Understand the need for 'Diversification'

Each fund house follows an investment process that ensures consistency of performance. By picking more than 1 fund house, you are reducing dependence on a single process or, in other words, protecting yourself from the failure of this process. This is technically not diversification but having a fail-safe. Diversification (as required by portfolio theory) is already built into a mutual fund.

3. ?Two? Good

This is one of the most common problems faced by investors who understand the importance of diversification. The ideal number of funds depends on factors like your investable amount, investment goals and risk profile. For equity mutual funds, you should not have more than 2-4 funds in your portfolio which are spread across different market segments and fund management styles.

Investing in a higher number of mutual funds will impair your capability to monitor the funds effectively. Besides, it may also result in repetition of stocks affecting the very basis of diversification.

(By Rahul Jain, Head-Personal Wealth Advisory, Edelweiss)

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