How many mutual funds should you invest in?

There is a maxim that advises investors, “Don’t put all your eggs in one basket”. This means that it is very important to always have a diversified portfolio and many investors are aware of this. But investors generally assume that it is not good to invest in just one or two mutual funds, but spread their investments across many mutual funds. So, investors feel that investment in two mutual funds is better than one mutual fund, investment in five mutual funds is better than two mutual funds, and so on. Eventually, at some point, diversification becomes pointless. Investors feel that they are well-diversified if they have invested in lot of mutual funds.
 
But beyond a certain point, investing in too many mutual funds does not provide any additional diversification benefit, as mutual funds are a way of holding investments in stocks, bonds, etc. and are not an investment in themselves. When you add more funds having similar stocks, you will not get any benefit of additional diversification.
 
Let’s understand what diversification means. Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. In case a particular stock or sector underperforms the markets in general, only the money invested in that particular stock or sector would get affected. In a scenario where the entire market is declining, diversification will not help you.
 
It is very important to track and evaluate one’s portfolio periodically to know whether the investments are performing per the intent with which investments were made. However, having lot of mutual funds in the portfolio may make the task of tracking and evaluating difficult and cumbersome. It becomes all the more difficult for you to meet your financial goals if you have too many mutual funds in your portfolio. Therefore, the ideal number of mutual funds for your portfolio could be three or four, although this number may vary depending on the size of one’s investment.