How many funds do you need for a diversified portfolio?

Imagine you are preparing for a long road trip across varied terrain—mountains, highways, and villages. Would you rely on just one mode of transport? Certainly not. Similarly, when it comes to investing, placing all your money into one mutual fund can expose you to unnecessary risk. Just as a traveler needs different vehicles for different routes, investors need a mix of funds to weather market ups and downs. This is where mutual fund diversification steps in.

Building a diversified mutual fund portfolio is essential, but investors often misunderstand the concept and end up complicating their investments. Instead of improving returns or reducing risk, too many funds can make your mutual fund portfolio diversification chaotic and inefficient. Let us unpack how many funds you actually need to maintain a diversified mutual fund portfolio.

The importance of diversification

The timeless advice, “Do not put all your eggs in one basket,” holds true in the world of investing. Diversification reduces the risk of capital loss by spreading investments across various asset classes, sectors, and market capitalisations. A well-diversified portfolio protects you when certain areas of the market underperform. However, a key mistake many investors make is assuming that holding 10–15 funds automatically means their portfolio is diversified. In reality, if many of these funds invest in the same or similar securities, then there's little to no actual mutual fund diversification. The idea is to reduce exposure to fund manager risk and specific sectors while optimising returns, not simply to hold a large number of funds.

How many funds are enough?

Most mutual fund schemes are already diversified to some degree. But investing in only one fund means you are relying solely on the strategy and decisions of one fund manager. This introduces fund manager risk—if they underperform, so does your portfolio. The general consensus is that holding around three to four funds from different categories is sufficient for effective mutual fund portfolio diversification. Going beyond that can result in portfolio overlap, where multiple funds invest in the same set of stocks, defeating the purpose of diversification. An overloaded portfolio becomes harder to track, monitor, and rebalance. So, to answer the question—how many funds do you need? Ideally, no more than four. This provides enough exposure without creating a portfolio that’s messy or inefficient.

Types of funds to include

Now that we have established the ideal number of funds, the next step is choosing the right categories. Picking funds from varied categories ensures true diversification and coverage across market capitalisations and asset classes. Here are five key types of mutual fund categories Indian investors can consider:

1. Equity linked savings scheme (ELSS)

This should ideally be your first investment. Not only does an ELSS fund help you save taxes under Section 80C, but it also acts as a multi-cap fund, investing across large, mid, and small-cap stocks. It is an excellent starting point for building your diversified mutual fund portfolio.

2. Aggressive hybrid fund

Aggressive hybrid fund formerly known as Balanced Funds, these invest in both equity and debt instruments. By holding at least 25% in fixed-income assets, they bring down overall portfolio volatility. Their hybrid nature offers a cushion during equity downturns, making them ideal for conservative investors.

3. Multi-cap fund

A multi-cap fund invests across companies of all sizes—large, mid, and small caps. This flexibility allows fund managers to take advantage of opportunities across market segments. Including a multi-cap fund ensures a broader market reach and is a key pillar of mutual fund diversification.

4. Large and mid-cap fund

This category focuses on the top 250 companies in India, offering a combination of stability and growth. While large caps are industry leaders, mid-caps represent emerging growth opportunities. Including this category brings balance and potential upside to your diversified mutual fund portfolio.

5. Small Cap Fund

This category invests in companies ranked beyond the top 250 by market capitalisation, focusing on smaller, high-growth potential businesses. While small caps offer the possibility of substantial long-term returns due to their expansion potential, they also come with higher volatility and risk. Including a small cap fund in your portfolio adds a dynamic growth component, especially suited for investors with a longer time horizon and higher risk appetite.

Each of these categories brings a unique flavour to your portfolio, reducing dependency on any one asset class or market segment.

Conclusion

In conclusion, effective mutual fund portfolio diversification does not require a long list of funds. What matters more is selecting the right types of mutual fund categories and sticking to a disciplined allocation strategy. A mix of just three to four funds—one from each key category—can deliver sufficient diversification for most retail investors. Also, do not forget the role of tools in planning. Using a SIP Calculator can help you plan your monthly investments effectively across these selected funds. This ensures you stay on track with your financial goals while maintaining a well-balanced and efficient portfolio.

To summarise, your investment portfolio does not need to be extensive to be diversified, it just needs to be thoughtful. A curated set of four funds, spread across strategic categories, offers simplicity, manageability, and, most importantly, true diversification in the Indian context.

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