Do you own too many mutual funds? How overdiversification can hurt returns

I often hear financial experts, friends and social media influencers talk about the importance of portfolio diversification. "Don't put all your eggs in one basket" is perhaps one of the most repeated pieces of investment advice.

But recently, during a discussion with a few friends about mutual funds, another term came up: overdiversification.

One friend proudly said he owned 14 mutual funds, several stocks, gold ETFs and even a few international funds. Before anyone could congratulate him on being a disciplined investor, another friend joked, "Do you actually know what's inside all those funds?"

The table burst into laughter, but the question lingered.

That got me thinking. We all know diversification is important. But can there be such a thing as too much diversification? And if yes, where exactly should investors draw the line?

WHEN MORE ISN'T NECESSARILY BETTER

Imagine a student preparing for an exam. Reading from three or four good books can improve understanding. But if that student starts collecting 20 books covering the same syllabus, the result may not be better performance. It may simply create confusion.

Investing often works in a similar way.

"Diversification is a tool to manage risk, not an investment strategy to generate returns," says CA Kresha Gupta, Director and Fund Manager at Steptrade Capital.

According to Gupta, the purpose of diversification is to protect a portfolio from single-point failures, not to maximise returns by endlessly adding investments.

"Always ask the question before diversifying – is this stock going to make my portfolio stronger or just larger?" she says.

That distinction is crucial because many investors mistakenly equate a larger portfolio with a safer one.

THE HIDDEN PROBLEM OF PORTFOLIO CLUTTER

One of the biggest misconceptions in investing is that more funds automatically mean more diversification.

Take a common example. An investor owns 12-15 mutual funds across large-cap, flexi-cap, multi-cap, value and index categories. On paper, the portfolio looks highly diversified.

In reality, many of those funds may be holding the same stocks.

Nishant Shanker, Chartered Accountant and Tax & Investments expert at Navraj Global Advisors, says this is one of the most common examples of overdiversification.

"Despite managing numerous funds, the portfolio often ends up delivering returns similar to a broad market index while requiring significantly more monitoring," he explains.

In other words, investors may be doing extra work without receiving any meaningful benefit.

THE WARNING SIGNS YOU SHOULDN'T IGNORE

How do you know whether your portfolio has crossed the line?

Experts point to several red flags.

You own multiple funds with similar portfolios.

You struggle to explain why certain investments are in your portfolio.

You keep adding new funds every year without reviewing older ones.

Your returns closely mirror benchmark indices despite holding dozens of investments.

Gupta says another warning sign appears when rebalancing becomes overwhelming.

"You cannot even track why you bought certain holdings or how they are actually doing. Costs creep up through expense ratios and transaction fees without delivering better risk reduction," she says.

At that stage, diversification stops helping and starts creating confusion.

THE SILENT COST OF OVERDIVERSIFICATION

The real danger is not immediate. It emerges slowly over time.

Diversification certainly reduces risk, but only up to a point. Beyond that, adding more investments often reduces the impact of your best-performing ideas.

"When one keeps diversifying the portfolio by adding different stocks in the basket, the portfolio moves closer to average returns," Gupta says.

That matters because compounding rewards even small differences in annual returns.

A portfolio generating 15% annually can create significantly more wealth over 15 years than one earning 10%. Yet excessive diversification often drags portfolios toward average market returns.

The result is a safer-looking portfolio that may actually produce lower long-term wealth.

WHY THIS PROBLEM IS GROWING

Today's investors have more choices than ever before.

There are hundreds of mutual fund schemes, ETFs (Exchange-Traded Funds), international funds, REITs (Real Estate Investment Trust), InvITs (Infrastructure Investment Trusts), thematic funds and alternative investment products.

While greater choice is a positive development, it also creates new challenges.

"More options can increase the risk of duplication and unnecessary complexity," says Shanker.

Gupta agrees.

"In India, we now have many ETFs and countless mutual fund schemes, so investors often end up holding three or four large-cap funds that own the exact same top stocks," she says.

Easy investing apps have made buying new products incredibly simple. Unfortunately, they have not made portfolio reviews equally popular.

SO, HOW MUCH DIVERSIFICATION IS ENOUGH?

There is no universal formula.

The right level of diversification depends on factors such as risk appetite, investment goals, portfolio size and investment horizon.

Still, experts believe many investors need far fewer holdings than they currently own.

Shanker suggests that 2-4 well-chosen mutual funds may be sufficient for many investors. Direct equity investors can often achieve adequate diversification with around 15-20 quality stocks.

Gupta emphasises that investors should focus less on the number of investments and more on asset allocation, sector exposure, investment style and geography.

For most retail investors, a combination of equities, fixed income and gold can provide a solid foundation.

The goal is not to own everything. The goal is to own the right things.

HOW TO SIMPLIFY AN OVERDIVERSIFIED PORTFOLIO

The first step is surprisingly simple: make a complete list of your investments.

Then identify overlaps.

Do multiple funds own the same stocks?

Are there investments whose purpose you no longer remember?

Are there tiny allocations that contribute little to returns?

"Each investment should have a defined role," says Shanker. "Redundant funds and duplicate exposures can then be consolidated gradually."

Gupta recommends a periodic review process rather than continuously adding new products.

"Most overdiversification happens through accumulation over time — one SIP here, one tip there," she says.

An annual portfolio review can often reveal how much clutter has quietly built up.

THE BIGGEST MYTH ABOUT DIVERSIFICATION

Perhaps the most important lesson is that diversification is not about quantity.

It is about quality.

Many retail investors believe they need exposure to every available asset class, i.e., equities, bonds, gold, silver, crypto, international funds and more, to be properly diversified.

Experts disagree.

"The biggest myth is that owning more investments automatically makes a portfolio safer," says Shanker.

A portfolio with four carefully selected investments can sometimes be better diversified than one containing twenty overlapping investments.

The real objective is not to collect investments like trophies. It is to build a portfolio that matches your goals, risk appetite and time horizon.

Because in investing, just as in life, more is not always better. Sometimes, simplicity is the smartest strategy of all.