Diversification : How many Mutual Funds should I own ?

Hi Friend,

How many Mutual Funds are required to adequately diversify one’s actively managed Equity portfolio is a question that is not easy to answer for both investors as well as for advisors.

At the beginning of a relationship, if an advisor makes a client invest in just one fund, the client may want to ‘diversify’ in to ‘more’ number of funds. 

But, even after investing in four funds, it generally happens that a client still would ask for ‘more’.

An advisor can not be sure of what this ‘more’ means in exact number and it happens that the investors who always ask for ‘more’ do not clarify it either.

Guess this ‘more’ arises out of ‘fear’ and the ‘confusion’ created by various sources of information.

Some of the sources of confusion are,

• Lack of clarity in most of the news articles , magazines etc., on whether they are talking about diversification in Stocks or Diversification in Mutual Funds.

• Forgetting the basic fact that an Equity based mutual fund is already a diversified vehicle of stocks. One shouldn’t forget that generally every mutual fund has around 30 to 40 stocks or even more.

Here is what Mr.Phil Fisher have to say on the pitfalls of wrong interpretation of diversification,

• Investors have been so oversold on diversification that fear of having too many eggs in one basket has caused them to put far too little into companies they thoroughly know and far too much in others about which they know nothing at all. 

• It never seems to occur to them, much less to their advisors, that buying a company without having sufficient knowledge of it may be even more dangerous than having inadequate diversification.

How much diversification is required ?

The best way to answer this question would be Mr. Charlie Munger’s Technique of “Inversion”. i.e. One can get the optimal number of funds by answering, “What can not be construed as diversification in ‘Active Fund Management’ ?” 

As the number of funds increase in a portfolio, we may be investing in almost all the companies of the index / market that matter i.e. we may be buying the entire market .

But, if we buy the entire market how can we beat the market ?

The basic purpose of active management will be lost as the number of funds in a portfolio increases beyond a point .

What Great Investors and Theories have to say about the number of stocks required for optimal diversification may give us some clues. 

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“According to the modern portfolio theory, you'd come very close to achieving optimal diversity after adding about the 20th stock to your portfolio”.

“The number of securities that should be owned to reduce portfolio risk is not great; as few as ten to fifteen holdings usually suffice.” - Seth Klarman

“Adequate though not excessive diversification (which he defined as between 10 and about 30 securities)” - Benjamin Graham

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Needless to say even just one “perfect” mutual fund would have more than the required amount of 10 to 30 stocks in an Ideal portfolio. 

As we can’t be sure of the the “perfectness” of a fund, having 3 to 4 funds in a portfolio, giving us the flexibility to invest across various market caps, to take advantage of tactical opportunities etc.,  should be a reasonable diversification. 

One should not forget that Three to Four funds would generally contain at least 60-100 unique companies.

To finish off,

“Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.” - Charlie Munger

Sources:

http://www.valueinvestingworld.com/2016/01/phil-fisher-on-diversification.html

http://www.investopedia.com/articles/01/051601.asp

https://25iq.com/2013/01/16/charlie-munger-on-investment-concentration-versus-diversification/

Thank you.