Most freefincal readers would be familiar with this question and perhaps more familiar with the answer – do not hold more than 3 or 4 funds. More funds do not mean higher diversification!
So why bother writing another post on this?
In academia, we have a saying: there is no such thing as a dumb question but there is definitely such a thing as a dumb answer!
When it comes to personal finance, perhaps the more appropriate adage is, ask a piece-meal question, you get a generic answer. Ask a holistic question, you get a holistic answer.
“Do not hold more than 3 or 4 funds. More funds do not mean higher diversification” represents a generic answer to a generic question.
Since personal finance is excessively personal, asking generic questions and taking the ensuing generic answers seriously is waste of time and effort.
So most often, the trouble is with the question.
‘Which is the best health insurance plan?’ is a generic question.
‘Which is the best health insurance plan for me?’ is a holistic question.
‘Experts’ and enthusiasts most often deal with generic questions all the in the name of financial literacy.
Only the individual in question can answer holistic questions!
So what is the holistic question in this case?
To answer this, let consider the case of Calvin’s dad who works as a patent attorney. His Son Calvin is a 6 year old (with a certain stuffed toy!).
Calvin’s dad, let us call him Bill(!), started investing for retirement about 12 years ago via SIP in a diversified equity mutual fund. After Calvin was born, that is six years ago, he double the SIP amount to fund Calvin’s education.
Calvin will finish school after about 11 years, while Bill will retire after 20 years.
Bill believes a single mutual fund is enough to serve as the equity component for both retirement and Calvin’s education.
He expects 12% returns for his retirement goal and 10% for Calvin’s education.
First, here is a question for you: How much should Bill withdraw from the fund when (that is a little before) Calvin finishes school? The idea here is withdraw for Calvin’s education without touching the retirement corpus.
Catch my drift?
Now, what is the holistic question that involves the number of mutual funds one should hold?
Crude version of the holistic question: Bill should ask himself, I have two long term goals: my retirement and Calvin’s education. How many mutual funds should I hold?
Let us try to answer this:
To simplify things, let us assume a single equity oriented balanced mutual fund is enough to build a diversified portfolio for long-term goals.
Bill retirement and Calvin’s education are events that are expected to occur 9 years apart in time. That Calvin will graduate after 11 years and Bill is slated to retire after 20 years.
Let us first recognize that long-term or short-term, the risk-profile of the goal
- how important is it?
- how far away is it?
- what is the reasonable rate of return expected from a diversified portfolio? Etc.
is more important than the risk appetite of the investor
- how much risk can Bill stomach?
- Does he understand how equity holdings compound? and the typical kind of psychobabble used for risk profiling!)
Should Bill assume that the risk-profiles of the two goals, that differ by almost a decade in tenure, to be similar and use the same mutual fund for both goals?
Should bill use the same asset allocation (equity:debt ratio) for both goals?
Assuming the risk-profiles are similar (they are not!), what if Bill chooses to increase the monthly investment amount for each goal each year? What if this percentage increase is different for different goals?
Would it become easier to evaluate how much Bill should withdraw?
What if Bill had chosen to use 2 equity funds and 2 debt funds for retirement and chose to contribute more in each of these funds for Calvin’s education? He adjusts the contribution amount to initially match the asset allocation for each goal? Would it now become easier to evaluate how much Bill should withdraw?
Bill would then like to rebalance each year to ensure the asset allocation for each goal does not deviate too much from his original plan. Can you please chalk out a way in which Bill can rebalance? Is rebalancing easier with fewer funds? Note that the idea here is to rebalance without mixing the corpuses!
I have assumed Bill never changes his funds. Would it make things easier if fund changes are included?
Well, enough fooling around. Let us get to the central issue.
Exact Version of the holistic question: Assuming Bill builds a diversified equity portfolio with say, 3-4 mutual funds, can he use the same funds for all his long term goals? Or should he have separate portfolios for each long term goal with a few funds in each folio?
- Can Bill use the same portfolio for all long term goals so that the number of funds is kept to a minimum? This way, can he ensure that he does not mix the corpuses during rebalancing and the final withdrawal?
YES. Of course he can! Only because anything is possible! Would take some doing though. If you answer the above questions, you can check for yourself how easy it is!
- Is it practical to use the same funds for all long term goals just to keep the number of funds small so that it is ‘easier to manage’?
Put yourself in Bills shoes and seek your own holistic question first and the seek the holistic solution.
As for me, I have 3 long term-goals: retirement, my son education and his marriage. Each of them have different tenures, different return expectations and therefore different asset allocations.
I use separate mutual fund portfolios for each of my goals. This makes it easier to know the corpus value, net folio returns, rebalance etc.
I use the automated mutual fund and financial goal tracker to check my holdings and net portfolio returns.
People say it is tough to manage multiple funds. I don’t know what the fuzz is all about. Choose funds with a long history of decent performance and give it at least 5 years to perform. Don’t be worried about short term performance and stay invested. Monitor frequently but do not act unless absolutely required.
So far the only redemptions I have made are from ELSS holdings done years ago and for rebalancing. It takes less than 20 minutes to invest in them each month. If you are running a SIP, you save on that as well.
I review a fund with the automated rolling returns calculator or mutual fund returns analyzer only if there is a significant drop in performance. Even then, if the fund is doing well wrt to its benchmark and I have faith in the fund managers ability, I have done nothing (for e.g. see review on HDFC Top 200). The equity portfolio overlap checker helps me keep my portfolios reasonably diversified.
As far as I am concerned, dedicated portfolios for long-term goals is far more hassle-free. I know exactly how much to rebalance each year and withdraw from a corpus when the goal is due! I get a clear picture of the net portfolio growth and take corrective actions as and when necessary.
If we use the same funds for all goals, then the fate of all the goals hinge on the same funds. If each goal is separated by several years can you find anything smart about such a strategy?
Confusing a generic answer with a holistic one is injurious for fiscal health. It is not about the number of mutual funds that one should hold. It is about the number of long term goals that one has, and seeking out the most efficient way to manage them.
Picture courtesy: Scienceteacherresources.blogspot.in
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