Every investment advisor asks you to diversify your investments to safeguard them from sudden risks. But do you know you can overdo it?.
Have you ever stared at your investment account wondering if you’ve got too many mutual funds or not enough? I’ve been there! The question of whether it’s better to have multiple mutual funds is something that puzzles many investors from newbies to seasoned pros.
The truth is, there’s no one-size-fits-all answer, but there are some guiding principles that can help you make sense of your portfolio. Let’s dive into the world of mutual fund diversification and find out if more really is better.
The Diversification Debate: How Many Funds Do You Really Need?
When it comes to stocks, financial experts generally agree that a well-balanced portfolio contains about 20-30 stocks to diversify away the maximum amount of unsystematic risk. But here’s where things get interesting – a single mutual fund often contains five times that number of stocks!
So does that mean one fund is enough? Well, opinions are split.
The “One Fund is Enough” Camp
Some investment experts suggest that equity investors need just one broad index fund, such as the Vanguard Total Stock Market Index Fund. The idea is simple – buy a comprehensive index fund and let time work its magic.
Even investors looking for both stocks and bonds can achieve their desired asset allocation through a single balanced fund Talk about keeping things simple!
The “You Need More” Camp
Others argue that a single fund fails to provide adequate exposure to international investments. Their reasoning goes something like this:
- A global fund gives you a little bit of everything, but not enough of anything
- A better approach might be:
- A large-cap domestic fund
- A small-cap domestic fund
- An international fund (or two) covering developed foreign markets like Europe
- Another international fund for emerging markets (Pacific Rim, Latin America)
- A domestic bond fund if fixed income exposure is desired
That brings the total to about six funds. Not overwhelming, but definitely more than one!
Understanding the Style Box Approach
There are nine investment categories for domestic stocks in the traditional mutual fund style box. These are based on:
- Market capitalization (micro, small, mid, large)
- Investment style (value, mixed, growth)
Similarly, the bond style box has:
- Three maturity categories (short-term, intermediate, long-term)
- Three credit quality categories (high, medium, low)
But here’s the thing: you don’t need a fund in every single category. Just a few well-selected funds that match your risk tolerance and asset allocation goals will do.
When Diversification Backfires: Too Much of a Good Thing
People like mutual funds because they let you invest in a lot of stocks in one easy package. But it’s possible for too much of a good thing to be bad!
Adding too many funds can accidentally create what I like to call an “expensive index fund.” This happens when:
- Too many funds negate the impact any single fund can have on performance
- The expense ratios of multiple funds add up to a higher-than-average total
- The end result? Higher costs with mediocre performance
In my experience working with clients, I’ve seen portfolios with 15+ mutual funds that essentially track the market but cost way more in fees than a simple index fund would. Not smart!
There’s No Magic Number (But It’s Probably Not 20!)
There is no one “right” number, even though there are thousands of mutual funds from hundreds of providers. However, almost everyone agrees you don’t need dozens of funds.
In fact, many mutual fund companies now promote life-cycle funds (also called age-based or target-date funds). These are essentially funds-of-funds – one fund that invests in multiple underlying funds. The concept? Pick one life-cycle fund, invest everything in it, and don’t worry about it until retirement.
I’ve got to admit, there’s an appealing simplicity to that approach!
How to Build Your Own Mutual Fund Portfolio Without Overdoing It
If you prefer to construct your own portfolio rather than going with an all-in-one solution, here are some steps to keep your fund count reasonable:
1. Start With Your Objectives
- If income is your primary goal, you might not need that international fund
- If capital preservation is your focus, maybe skip the small-cap fund
- Your specific goals should determine which categories are necessary
2. Check for Overlapping Holdings
This is super important! Compare the underlying holdings of funds you’re considering. If two or more funds have significant overlap in the stocks they hold, eliminate the duplicates. There’s literally no point in owning multiple funds that contain the same stocks.
3. Compare Expense Ratios
When two funds have similar holdings, go with the cheaper one. Every penny saved on fees is more money working for you. I’ve seen cases where investors were paying triple the fees for essentially the same exposure!
4. Consolidate Small Positions
If you’re working with an existing portfolio rather than starting fresh, look at eliminating funds with balances too small to impact overall performance. Got three large-cap funds? Consider moving all that money to a single fund. Your diversification level stays the same, but your expenses likely go down.
Real-World Fund Combinations That Work
Let me share some practical examples of fund combinations that can provide excellent diversification without going overboard:
The Core Four (4 funds)
- A total US stock market index fund (40-60%)
- An international stock index fund (20-40%)
- A US bond index fund (10-30%)
- A small allocation to a REIT fund (5-10%)
The Simple Three (3 funds)
- A target-date retirement fund (80-90%)
- A specialized fund in an area of interest (5-10%)
- A money market fund for emergency cash (5-10%)
The Minimalist (2 funds)
- A global balanced fund (80-90%)
- A money market fund (10-20%)
Each of these approaches can work well depending on your specific situation. The key is intentionality – each fund should serve a distinct purpose in your portfolio.
When More Funds Might Actually Make Sense
While I’ve been harping on about keeping your fund count low, there are legitimate reasons to own multiple funds:
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Tax management – Different accounts (taxable vs. retirement) might need different fund types for tax efficiency
-
Access to specialized markets – If you want exposure to specific sectors or countries not covered by broad index funds
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Different time horizons – Having separate funds for short-term, medium-term, and long-term goals
-
Core and explore strategy – Using index funds for the bulk of your portfolio while adding a few actively managed funds in areas where you believe active management can outperform
Just make sure each additional fund serves a specific purpose that isn’t already covered by your existing holdings.
Signs You Definitely Have Too Many Funds
How do you know if you’ve gone overboard? Here are some telltale signs:
- You can’t name all your funds without looking at your statements
- Your portfolio performance closely tracks the market but with higher fees
- Multiple funds show the same top 10 holdings
- You have funds you haven’t reviewed in years
- Your quarterly statements resemble a small phone book
If any of these sound familiar, it might be time for some spring cleaning in your portfolio!
The Bottom Line: Quality Over Quantity
When it comes to mutual funds, it’s definitely a case of quality over quantity. Most investors can achieve excellent diversification with somewhere between 3 and 8 well-chosen funds.
Remember these key points:
- Each fund should serve a specific purpose in your portfolio
- Avoid overlap between funds
- Keep an eye on total expenses
- Regularly review your holdings to ensure they still match your goals
The goal isn’t to own as many funds as possible – it’s to build a portfolio that helps you reach your financial objectives with an appropriate level of risk and reasonable costs.
So, is it better to have multiple mutual funds? Yes, but with an important caveat – only if each fund plays a distinct and necessary role in your investment strategy. Otherwise, you might be better off streamlining your portfolio and focusing on a smaller number of high-quality funds that truly diversify your investments.
What’s your approach? Do you prefer the simplicity of fewer funds or the potential benefits of more specialized holdings? Whatever you choose, make sure it’s an intentional decision rather than a haphazard collection of investments that once seemed like good ideas!
Over-Diversification of Mutual Funds
The aim of diversification is to spread risk. If you invest too much in one company’s stock, you are at great risk.
If something happens to that company, a significant portion of your money could get wiped away. So to mitigate that risk, you buy shares of many companies.
And to mitigate risk further, you buy shares of companies from different industries. This means that even if a whole industry is doing badly, a lot of your money will still be safe.
But if you invest in too many companies, and one of them does very well, your investment won’t gain much. The company that did well would have had a very small impact on your total investment. So you should limit yourself to owning a few shares from most industries.
But should you apply the same logic to your mutual funds? No, not really. This is because equity mutual funds themselves buy shares from very diverse industries.
Typically, equity mutual funds at any point are invested anywhere between 50 to 100 shares. So when you invest in an equity mutual fund, you are indirectly owning shares of that many companies. Your portfolio is already very diversified!.
How Many Mutual Funds Should I Own?
Mutual funds are of many types.
Large cap equity mutual funds invest only in large cap company shares. Investing in many large cap mutual funds is not necessary. One well-chosen large cap mutual fund should be enough.
Mid cap equity mutual funds invest in mid cap companies only. Mid cap companies grow at much higher rates when compared to large cap companies. At the same time, the risk is also much higher.
After careful research, you can consider owning a few mid cap mutual funds. Because there are so many mid-cap companies, there is less chance that people will own shares in the same mid-cap mutual fund.
Small cap mutual funds, as the name suggests, invest in small cap companies. Small cap companies are very volatile and can lead to meteoric rises and spectacular falls. The risk in case of small cap mutual funds is very high.
The chances of overlap of shares are lower in the case of small cap mutual funds. But it must be remembered, these mutual funds are very risky.
Debt mutual funds, invest money in bonds and other market instruments. They are low risk, low returns mutual funds. Debt mutual fund returns are very consistent over time and somewhat similar.
Sectoral mutual funds invest money in certain sectors or industries only. From a risk perspective, investing in a sector mutual fund is almost the same as buying shares in one industry only. If you want to buy a mutual fund in any sector, you need to know a lot about that sector.
Should I Have Multiple Mutual Funds?
FAQ
Should I invest in multiple mutual funds or just one?
There is no one “right” number of mutual funds for your portfolio, even though there are hundreds of companies that offer thousands of funds. Despite the lack of agreement among the professionals regarding how many funds are enough, nearly everyone agrees that there is no need for dozens of holdings.
What is the 7/5/3-1 rule in mutual funds?
The 7-5-3-1 rule in mutual fund investing is essentially a behavioural framework designed for SIP investors in equity mutual funds. It encompasses four major aspects: time horizon, diversification, emotional discipline, and contribution escalation.
What are the disadvantages of multiple mutual funds?
Each equity mutual fund, for instance, invests in around 50 to 60 stocks. So, if you have 10 mutual funds in your portfolio, you have over 500 stocks. Too much diversification such as this can be detrimental to your portfolio because it can drag down the overall returns, without reducing the overall risk as much.
What is the 3-5-10 rule for mutual funds?
Section 2012(d)(1) of the 201940 Act says that an acquiring fund can only invest a maximum of three percentage points of its outstanding voting stock in an acquired fund, five percent of its total assets in any other acquired fund, and ten percent of its total assets in all other acquired funds.
