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Naïve diversification is real, and it can bloat your portfolio if you don't pay attention. Representative Image (Creative Commons)

One of the pressing issues for most mutual fund investors is how to manage the number of funds in their portfolio. The most “diversified” investors we have seen have over 50 funds.  A lot of online platforms fuel this fire by selling baskets of multiple funds perpetuating the “more is better” mantra for diversification. Similarly, every new advisor you hire adds “value” by adding his selection of funds to your portfolio. As a big proponent of intelligent and holistic advice, one of the first things we require of investors is to import their existing mutual fund portfolios to a single place. We let them do that on Kuvera.in in an easy and seamless manner that takes less than 3-4 hours.

Once imported, all your folios and funds are available to you in one place and you can analyse your complete portfolio in one place. Further, all our advisory features, such as portfolio overview and tax harvesting, work better if we can process the entire portfolio.

What we find when investors import their portfolio on Kuvera is a matter of concern. The average imported portfolio on Kuvera has a whopping 13.4 funds spread across Rs 10 lakh.

Academic approach

Academics has a term for this “more is better” approach to buying funds — naïve diversification. Academic studies in the US have shown that post 32 stocks, the diversification achieved by adding one more stock to your portfolio is negligible. Since almost all mutual funds have at least 40-50 stocks, they are well diversified already.

Daniel Fernandes of the Catholic University of Portugal examined naïve diversification in his paper “The 1/N Rule revisited” published in International Journal of Research in Marketing. Participants in his study were asked to allocate their savings amongst five funds. In one case four of the five funds were equity funds and in one case four of the five funds were debt funds. Not surprisingly, participants tended to invest 1/N in all available funds in either case thus taking more equity risk when they had more equity funds available to invest in. If you have ever selected a few funds from an equity category and eventually invested equally in each then you have fallen to 1/N naïve diversification heuristic.

The only argument to add multiple funds is if they have minimal stock overlap — so invest in a Nifty 50 fund, a Nifty Next 50 fund, a value based fund, an international fund and one debt fund. Essentially, the portfolio we recommend on Kuvera. A five-fund portfolio that takes care of all your needs. Proponents of passive investing will argue that just buying a Nifty 50 index fund and liquid fund is good enough.

New investors should be aware of this too, and take pro-active steps to not let their portfolios grow to too many funds. Over time it will become incredibly hard to manage and rebalance your portfolio and make any changes to it. To investors on our site who ask for advice to reduce the number of funds we offer a few simple rules of thumb. Not all of them may apply to you, but most of them will and can help you manage your unwieldly portfolios better. Just following the rules below and it will bring down the number of funds in your portfolio to 4-8 funds.

Five steps

1. Only one scheme per equity sub-category (e.g one large cap scheme).

2. If you are investing in market cap schemes (large, small, mid, etc) then don’t have a multi-cap scheme.

3. Avoid investing in sector or thematic schemes. Sector outperformance is notably hard to predict.

4. Invest in one fixed income scheme (debt or liquid). That’s right, just one liquid scheme is enough. Take risk on the equity side of the portfolio.

5. If you have both equity and debt schemes then don’t have balanced and hybrid schemes.

Further, we notice that nudging investors over time that they have too many funds also works. In different parts of our app we show how many funds the user has and compare it to the average number of funds owned by their peer group i.e. of investors of roughly similar age with a further nudge to keep the number of funds between 4 and 8. This has worked in helping our investors reduce their number of funds in the portfolio.

Naïve diversification is real, and it can bloat your portfolio if you don’t pay attention. Have strong reasons to add a new fund in your portfolio other than this fund. It will ensure you have a smart portfolio which will be easier to manage and rebalance as per your asset allocation needs over time.

(The writer is founder and CEO of Kuvera.in — a leading financial investments platform in India. Views expressed are personal)