Does owning large number of funds reduces your risk?

You may be prompted by your advisor or by one of your well-wishers to have funds for every reason and season. This will help you, according to them, to prepare yourself for every financial goal. Nevertheless, by following them, you will end up with too many funds in your portfolio. The problem with too large a portfolio is that it takes its own time to track and manage. John C Bogle in his book ‘Common sense on Mutual Fund’ writes that a single ready-made balanced index fund—holding 65 per cent stocks and 35 per cent bonds—can meet the needs of many investors.

Nevertheless, what is the maximum number of funds one should hold in his portfolio that will minimise his risk?  Going beyond four or five equity funds will neither increase your returns nor is it going to reduce your risk. Moreover, too large a number can easily result in over-diversification. To understand the impact of how the number of funds determines the riskiness of your portfolio; we did a study involving 15 funds from different fund houses. We took their last two-year daily returns data and gave them equal weightage to calculate the portfolio standard deviation, a popular measure of the riskiness of an asset. We found that as we keep on adding more funds, it started reducing the portfolio standard deviation. However, after a certain point of time, it started rising and then plateaued.



The above result is only for the funds that I have taken in my example. Depending on the nature of funds and their return distribution, the above graph will change. Nevertheless, one thing is clear, that as and when the number of funds increases, it stops reducing your risk incrementally.