Should You Invest in Multiple Funds Of The Same Category?
We all know about the importance of portfolio diversification. Since it reduces risk and offers a higher return, diversification is the optimum choice for investors. Nevertheless, as an investor, you need to know how much you should spread your investments so that it does not lead to over-diversification.
How many mutual funds to invest in?
In order to diversify their portfolio, investors sometimes choose to invest in two funds considering it to be better than one. Many investors end up investing in three to four funds within the same category in order to minimize risk. But is that right? Read on to get a clear idea about the issues of investing in multiple mutual funds of the same category:
- Excess diversification does not help
- Investing in same asset category does not diversify a portfolio
- Return and risk from investing in assets in the same category remain same
- The portfolio becomes difficult to manage
- Multiple funds may dilute the impact of the top-performing funds
Let us understand each of this in detail:
Excess diversification does not help
When you are investing in a lot of funds, diversification is pointless. Diversification is ideal for reducing risks, but investing in a number of funds will not help achieve the same. The truth is you cannot achieve diversification by investing in multiple funds across the same asset category. After a certain point, it has no impact on the portfolio.
Investing in same asset category does not diversify a portfolio
Mutual fund investment is not a portfolio investment in itself. The fund managers manage your investment and invest the amount across different securities. If you invest in the same category, your portfolio will remain the same. Mutual fund holdings maybe divided into debt and equity. If you have invested in equity and if you chose another fund in the same category, diversification will make no sense since the holdings will remain similar. By adding more funds into the portfolio, you are simply adding more securities and not diversifying the portfolio.
Return and risk from investing in assets in the same category remain same
The biggest advantage of mutual funds is to invest across different stocks and reduce the risk of loss. With investments made in different securities, the fund manager will ensure that the cost of transaction and the purchase price is low while the return is maximized. In case you are investing in best-performing mutual funds within the same category, you are only achieving what you could achieve with one fund. The fund manager will invest the amount into stocks, which will have the same impact on your portfolio like the other funds you have invested in.
The portfolio becomes difficult to manage
The advantage of a mutual fund is its organization and convenience. You may easily invest in a fund and manage it with convenience, but if you are investing in a large number of funds, it will become tedious to handle the same. Analysts suggest that investing in two to three funds may provide you with enough diversification. Any additional investment in the same category will not benefit. There will be no addition to the portfolio as well. So with multiple funds, you are simply adding them to your existing portfolio and making it difficult to manage.
Multiple funds may dilute the impact of the top-performing funds
By investing in multiple funds, there is a possibility that the positive effect of funds which are performing well is attenuated. If a fund is underperforming, it will overshadow the funds which are performing well. Similarly, if a fund is performing very well, it will overshadow the funds that are not performing up to the mark. With too many funds, you might be ignorant of a poor-performing fund and keep holding it for a long period of time. If you have a few schemes, you may take quick action in case of underperformance.
How to avoid it over-diversifying your portfolio?
To ensure optimum diversifications, which will benefit your portfolio mix, keep the following points in mind:
Do not allocate your money to same-category funds
It is important to remember that the purpose of diversification is to reduce the risk of your portfolio and it will not be achieved by investing in multiple funds, which fall under the same category. The fund managers will be investing in similar stocks across the category; hence choosing a couple of high-return funds is an ideal option. In order to create growth-oriented investment plans, you need to build a diversified portfolio, which will only make sense when you invest in different asset classes.
Go for an equity-debt combination
For a balanced portfolio, investment in a mix of growth and value funds is recommended. This will help you in generating higher returns through growth (equity-related) funds and maintaining a balance with value (debt-related) funds.
Ascertain your risk appetite and invest in mutual funds. Determine the amount you want to invest and the tenure you want to remain invested for. Choose best-performing mutual funds based on the same and make the right move.
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