How Many Funds Do You Need For Adequate Diversification?

Well, there is no magic number that can answer the question. More than the quantity, quality of diversification would matter. There is no point in having five funds, all with the same / similar investment approach. This is not going to give you the real diversification that you are looking for. So diversification would need to be done across:

Asset classes: It is prudent to spread your money among various assets like equity, debt and gold. This ensures that you participate in the out performance of these assets which usually happens at different points in time.

Market capitalizations: Putting all your money in many schemes, all operating in the same market cap too is not optimal. You would need a blend of large, medium and small cap funds to build a good portfolio due to the varied risk and return characteristics that each of them exhibit.

Investment styles and strategy: There are many investment styles like growth investing, value investing, dividend yield strategy, special situations strategy etc. A good portfolio will have a blend of these styles.

Geographies: You would also do well to spread your money in more than one country. This is to safeguard against geo-political events and currency risks. Every country has its own strengths and weaknesses and geographical diversification ensures that you get the opportunity to participate in the other growing economies, also thereby reducing country-specific risk.

Sectors and Themes: If your risk appetite permits, one should also allocate a small amount of the total portfolio (may be 5 or 10%) to sectors and themes which would do well in the time to come. However, this should not form part of the core allocation of your portfolio.

In a nut shell: Diversification is a must for mutual fund schemes too. The focus should be on the quality rather than the quantity of diversification. Constituents of the portfolio must complement each other in minimizing risk and generating returns.