By Arnav Pandya Nov 27 2014

Investors constantly worry about the number of funds that they should have in their portfolio. While the debate often ranges between having too many and not so much, there is also another angle to consider.

Some experts believe that just 1-2 funds in a specific category can do the job for the investor as efficiently as what would be seen if the number was doubled. The question then is whether 1-2 funds in a category would be enough. Here is a closer look at the issue and how the individual can go about the entire process.

Diversification

One benefit that every investor wants to avail of is that of diversification. This is nothing but the fact that spreading out your investments across multiple areas or asset classes or even choices would ensure that all of them do not perform in the same way at the same time and hence provides an element of comfort and safety to the investment.

The problem with using this concept is that investors seem to take only a part of the process into consideration which is that of the spreading out of the investments.

In this situation they end up believing that more is better because this will spread the risk and hence they are being effectively protected when this actually occurs in their portfolio. However the key thing for them to understand is that just because they spread out their investment does not mean that their portfolio is being diversified.

Overdiversification

In many cases especially with respect to mutual funds what happens is that the investor ends up adding too many funds to their portfolio.

This makes the number actually far more than what is actually required and at the same time this does not do much to the process of diversification. There is also a limit to the benefits that the process can bring in and the theory also says that diversifying too much can lead to very negligible benefits as the number of holdings increase. This is the reason why individuals find that having 12-15 funds in their portfolio actually does not do much in terms of helping them out with their needs but actually becomes a difficult proposition to manage.

Mutual funds are different

The investor has to take a different view as far as mutual funds are concerned because of the fact that this is a different kind of instrument and hence this has to be evaluated separately. Unlike a normal investment in a stock or a bond, a mutual fund already consists of many holdings so the fund is already doing the diversification work for you.

The investor who tries to add too many funds to their portfolio and diversify further is actually not doing anything different but is adding on to the work of the mutual fund that has already constructed a diversified portfolio.

Final outlook

Focusing too much on adding more funds to the portfolio might not help. Investors might be better off if they have just 1-2 funds in a single category so that they are able to get the required exposure to that category and if there is a larger amount of money present with them for their investment then they could ensure that there is an additional fund added on.

Due to this reason there is no need for the investor to try and add too many holdings to their portfolio but they would be fine with a minimum number where the fund manager is already doing the diversification work for them.

Once this is clear then the overall portfolio construction process also becomes easier and there is a clear direction to the goal of the portfolio.

(The writer is a CA and Certified Financial Planner)