The Danger of Over-Diversifying in Mutual Fund Portfolio

There is an age old saying, “Don’t put all your eggs in the same basket.” This is basically the principle that a mutual fund follows when deciding where the money is actually invested. Sometimes mutual fund investors may take this theory to heart and invest in too many funds at the same time. While there is nothing wrong with doing this, there is one that you should watch out for and that is the danger of over diversification of the portfolio. With an over diversified portfolio you can find yourself in a situation where even investing in the best mutual funds in India will not provide returns to the tune you were hoping for.

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What is over diversifying?

Let us take an example of an average person. This person has decided that he is going to invest Rs. 30,000 in mutual funds. When the time to invest comes, he takes a list of the top 10 mutual funds in India and invests Rs. 5,000 in 6 different mutual funds. This can be called an over diversified investments because the ideal number of investments he could have made with this amount should have been 1 or 2.

Why is over diversifying bad

There is no doubt that over diversified investments in mutual funds are bad and the reasons for this are:

• Can’t buy much: With a small investment, the returns too will be small since the invested amount will not be enough to buy too many units..

• Building wealth will take long: Since the invested amount is small, and the number of units bought through them is also small, when it comes time to see how much wealth has been built, there will be a lot of disappointment since the amount built won’t be significant enough to make a difference.

• Reduction in benefits: If one or two of the investments were made in tax saving mutual funds (ELSS) then the tax benefit available to the investor will be only Rs. 6,000 to Rs. 12,000 instead of Rs. 30,000.

• Small hits big damage: The very nature of mutual funds speaks of an inherent risk in the investment. When the invested amount is small, its capacity to sustain losses is reduced and even a small loss can do a lot of damage to the portfolio.

• Similar investment: There could be a chance that some of the mutual funds may be investing in the same company. This means that the whole purpose of diversifying to invest in different sectors or companies will be defeated.

• Expensive to pay for: Most mutual funds will charge an entry load and fund management charges. Will investments in 6 different funds, the service charges alone for our investor will end up losing him money.

• To many threads to track: When you invest in too many mutual funds, you are more than likely to find it reasonably tough to keep an eye on each and every one of them at the same time.

The fact is that there is no formula or magic number that can tell you how many mutual funds you can invest in. The decision must be made by you after you have understood how much money you have to invest and what sort of returns you can expect out of the investments. If you are still convinced that you want to invest in more than one fund then it would be best to consult a financial advisor who can help you decide on what to invest and where so that you can get the most out of your money.