Over the last two years, more and more investors have bought units of equity mutual funds. Equity related schemes have received net inflows of around Rs. 72,000 crores year-to-date (YTD) as per data from AMFI (Association of Mutual Funds in India). However, buying too many popular and star-rated equity funds may be counterproductive for creating wealth.
Many investors buy a lot of different mutual funds for their portfolios, following the concept of diversification. But having too many funds creates an index-type portfolio and cancels all advantages that come with proper diversification.
Read along to find more about why you should not hold too many equity funds and how to readjust your portfolio.
The Problem of Over-diversification
Diversification refers to the process of investing in stocks across different market capitalizations and sectors. This helps to cushion sudden market corrections as the stocks are not over-exposed to a particular sector or market cap. A portfolio with the correct diversification reduces the swings in returns and makes for a stress-free investing experience.
However, inexperienced investors often end up investing in 15-20 mutual funds, which takes the concept of diversification too far. All mutual funds invest in a portfolio of securities to reduce sector-specific risks. As a result, having too many equity mutual funds would be completely pointless.
What is the Right Number of Mutual Funds in a Portfolio?
All benefits that come with diversification can be achieved with a smaller number of funds. Some experts recommend having no more than 5-10 mutual fund schemes, depending on the size of one’s portfolio. These should include equity funds, debt funds, hybrid funds and ELSS funds etc.
Other experts believe that there is no ideal number of funds to include in a portfolio. While having fewer funds in a portfolio may be a good idea for a small investment, larger ones may require a bit more diversification. Moreover, they consider diversification a good idea for debt funds.
Common Mistakes to Avoid When Investing in Equity Funds
Here are some of the common mistakes investors should avoid when investing in equity funds:
Funds with less than 5-7% weight in portfolio: A mutual fund investment in your portfolio with too small allocation will not offer high returns even if it massively outperforms its benchmark index. Unfortunately, it is not uncommon to invest a small random amount on an ad-hoc basis.
Investing in too many mid-cap and small-cap funds: While these funds offer chances of best returns, they carry considerable risks. If you do not have a very high-risk tolerance, you should limit your investment in mid-cap and small-cap funds.
Holding underperforming schemes: If a fund is consistently underperforming its benchmark index and category peers, you should exit such schemes immediately. But do not take such decisions for short-term underperformance.
Keeping sector or thematic funds for too long: It can be very tempting to buy sector/thematic funds based on your temporary bullish view on the sectors. These funds are very risky due to the concentrated nature of the portfolio. Hence, timing the entry and exit of such investments is crucial to get good returns and not lose money.
Things to Consider When Investing in Equity Mutual Funds
The following are some things to consider for getting the best returns and reducing risks from equity fund investments:
Asset allocation: There is no standard answer for deciding the asset allocation for an investor’s portfolio. One should always invest in both equities and debt instruments to maintain balance and avoid erosion of returns.
Risk tolerance: This refers to the investor’s ability and willingness to tolerate losses in exchange for the potential to get higher returns. Having more equity investment requires the investor to be aggressive, i.e. willing to lose more money for better results.
Risk versus rewards: In investment, risks and rewards are closely related. For example, investors looking for the best returns may invest in mid-cap and small-cap funds, but these could deliver sharp underperformance in the short run. On the other hand, risk-averse investors may choose to invest mostly in large-cap funds.
Investment horizon: This refers to the expected time (months, years or even decades) an investor has to wait to achieve their financial goals. An investor with long-term goals may end up taking a more risky and volatile position as they can wait out slow economic cycles.
Diversification is not the end-all solution to get the best returns out of your equity fund investments. If you have a large number of equity schemes, you may want to downsize your portfolio to cushion it from sudden market corrections and get steady returns.
Before investing in equity funds, it is recommended to check your investment goals, risk appetite, and investment horizon.
Frequently Asked Questions
What are the tax implications of investing in equity funds?
If the units are redeemed after a year, long-term capital gains (LTCG) are applicable at a 10% rate over gains of Rs. 1 lakhs. Otherwise, short-term capital gains (STCG) is applicable at a 15% rate.
What does rebalancing a portfolio mean?
Over time, some investments may become misaligned with an investor’s financial goals. That is when they can rebalance their portfolio by selling or purchasing units of mutual funds to bring back the original asset allocation mix.
What are large-cap equity funds?
These are open-ended equity funds investing at least 80% of total assets in equity and equity-related instruments of large-cap companies.
Disclaimer: This blog is exclusively for educational purposes and does not provide any advice/tips on investment or recommend buying and selling any stock.