January 30 , 2013
One feature that strikes me about most customer portfolios is the number of items they hold. In stocks, mutual funds or insurance policies, people seem to think 'more the merrier'. Often, several of these stocks or funds do not constitute even 5% of the total portfolio.
The truth is - even the most seasoned of investors having a passion for research can rarely monitor more than 10 stocks or funds. In practice, due to lack of time, we can manage even fewer, often none. So then why do we end up with so many policies, stocks and funds?
Flawed idea of diversification
One reason for this is a wrong understanding of the concept of diversification - people are so worried about one or two items going bad, that they try to compensate with two others. And so on. The fact is, a single mutual fund is itself a fair diversification – it often holds 25 stocks from different sectors.
If you have about three such generic equity funds, you will likely hold most of the top 100 market stocks. More funds only lead to overlapping holdings of the same stocks, not further diversification.
Victims of hard selling
Possibly the bigger reason for this proliferation is the questionable sales role of agents. Most of us buy funds only when pestered by agents. Till recently, new funds paid out higher commissions to agents, so they were busy pushing new funds instead of tested old ones. Thankfully, the regulator has put an end to this practice by removing agent commissions altogether.
There is a third reason – we often want to try out something new. The idea is good, but the implementation is flawed. If you really look closely at your portfolio, you will discover that most funds are different in name only – they often hold very similar stocks. And if you have gone for several thematic funds, be assured that at any given time more than 2-3 themes are unlikely to succeed. So you should try and identify these 2-3 themes and invest; rather than throw several darts in all directions.
Thumb rule for investment portfolio
If you are a passionate investor, go for 2 mutual funds, 10 stocks and 1 life insurance policy. If not, go for 3 funds and 1 life insurance policy. No stocks.
Ideal number of mutual funds in your portfolio
The basis for this thumb-rule goes back to our experience with mutual funds and stocks. Three well chosen diversified mutual funds (or index funds) give you all the diversification you need. Any more only add to your complexity, and will likely lower your returns. These three mutual funds would work well for beginners and pros alike, since the fund managers are experts who are dedicated to manage your money well.
Ideal number of stocks in your portfolio
Passionate investors are never content with leaving all their money in funds. In this case stock investing after research is fine. Practically, research of over 10 stocks on ongoing basis is impossible – so this makes the upper limit for stocks on your portfolio.
Also, stock investing can often degenerate into stock 'trading', which means short term purchase and sale of stocks based on tips. Brokers are known to encourage this behaviour, since they make money only when you transact, not when you hold a set of stocks over the long term.
People with no time or interest in finance need not worry – the three funds above can take care of your long term needs pretty well. You can have up to two other thematic funds, based on the economic scenario. But if you don't care for even this, it's perfectly fine. Avoid the temptation of direct stock investing - it can make money only if you have the time and perseverance for research.
Insurance as investment
Insurance again is a big con-game in the market with agents recommending myriad endowments, unit-linked plans, pension plans and child plans. We have often seen how customers have several policies, and yet insufficient life cover.
In truth, you just need one plan - a term insurance plan. This gives your family a pure insurance cover and does not mix it with investments (which are taken care of in the funds above). One such plan covering 4-10 times your annual income should suffice. Thereafter, you need not consider any other plan at all.