Designing the right-size portfolio The famous maxim referred to as the “Occam’s Razor” goes like this – “entities must not be multiplied beyond necessity”. Keeping with this maxim, a portfolio that is of a correct size should satisfy two clauses – a necessity clause and a sufficiency clause. These refer to how many funds are necessary to have in a portfolio and how many schemes are sufficient, meaning any more would be of no extra value.
To determine what is the minimum number of schemes you should have in a mutual fund portfolio, let’s look at the objectives of any such portfolio:
An investor is looking for diversification, risk-mitigation, and returns that are, overall, better than the market returns. Broadly, there are two asset classes available for regular investors – equity and debt. If an investor is looking to have a well-diversified portfolio, an equity holding and a debt holding are must-haves. So, that gives us a starting point of two schemes in the portfolio. (Of course, there are balanced-funds which promise to hold both, but by holding them, an investor loses control over the allocation between asset classes).
Equity schemes When you invests in a diversified equity fund, you are doing so trusting the fund house reputation, and the fund manager’s performance over a period of time. Of course, “past performance is no guarantee of future results”. A fund-house could undergo structural changes, and fund manager might move or have a bad year. So, it would be prudent to be invested in more than one equity scheme. That gets us to a minimum of two equity holdings in a portfolio. Also, having two schemes gives one the flexibility of investing in a tax-savings (ELSS) fund and in one regular fund.
Debt schemes In a debt scheme, the need to mitigate risk and be diversified is the same. The fund manager’s performance matters a little less in debt schemes when compared to the interest rate scenario in the country and the world at large. To be well covered in multiple scenarios, you would need to hold a scheme that specializes in short term debt and one that specializes in long-term debt. Again, the number is two.
Tools: Allocate your assets
Four is the number! That gets us the minimum size of a good mutual fund portfolio – four. Now, what would be the maximum size? What would be a sufficient number of schemes beyond which things get too complicated?
This was a tricky question. But how many is too many? To find out, I turned to Shankar Bhatt, our resident financial advisor. Shankar has been advising clients for about a decade now, has advised people of various stripes – age, profession, net-worth, and has seen a variety of colorful financial situations. I spoke to him about my cousin’s 21 scheme portfolio and asked him, “So, how many schemes are too many in a portfolio?”
“Well,” he said, “I have managed portfolios that are worth several crores. At no time did I feel the need to have more than seven schemes in a portfolio for any individual. I usually manage with about five or six.”
This upper limit is all the more essential for do-it-yourself individual investors. That limit, researchers have found, is seven. As a portfolio size grows above this number, an individual’s capacity to track and stay on top of their investments starts diminishing rapidly. This, he said, would hurt the performance of their portfolio significantly over the long run.
Thumb rules Follow these two thumb rules to determine if your portfolio is too big for you:
1. Can you name all the schemes in your portfolio without fetching a folder full of statements and transaction slips? 2. Can you keep up with the financial news in reference to your portfolio? For example, if there were an announcement on the TV about the GDP growth rate or the rate of inflation, would you be able to figure out how much of your portfolio is impacted by this news?
Smart investors should be able to understand news and be able react and modify their portfolio if needed.
Maintaining the right size for your portfolio is as important as putting it together to begin with. Typically, portfolios are not born complicated; they grow that way over a period of time. The key to keeping your portfolio at a small, manageable size is simply to have a plan and sticking to it.
Any future investment (including SIP investments) or redemption decision will need to be in line with this plan.
Shankar, however, sounded a cautionary note: The number of schemes in your portfolio is an important metric, but it’s just one metric. As important, or probably more important, is the asset allocation and balancing the overall investment portfolio, not just your mutual fund portfolio, between debt and equity components.”
Final words Remember that as the number of funds in a portfolio increase, the less manageable it becomes, potentially hurting its returns. And an ideal number of funds in a portfolio, regardless of the amount of money invested in it are between four and seven.