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How Many Funds Should I Own?

by

Jack Piazza
Sensible Investment Strategies

Diversification in an investment portfolio is universally recommended -- it is not only desirable, it is necessary to achieve an effective, well-defined investment strategy. Yet, the optimum number of funds in one's mutual fund portfolio is an issue subject to wide opinion because there is no standardized formula to determine the quantity of funds in any given portfolio.

Let's first review what mutual fund diversification is and what it accomplishes for an investor. Ideally, diversification spreads an investment portfolio among different fund categories to achieve not only a variety of objectives, but also a reduction in overall risk. Different fund types (i.e., large growth, mid value, small growth, etc.) offer distinct risk/return objectives; diversification increases as the combination of different risk/return objectives increase. The following fund categories depict different risk/reward objectives on an escalating risk basis:

    Stock Funds:
    large value<large growth<mid value<mid growth<small value<small growth<international<sector<emerging markets

    Bond Funds:
    short-term<government mortgage<intermediate-term<multisector<long-term<high-yield<international<emerging markets

    The emergence of specialty fund categories and style classifications have increased the number of funds now available. For example, international stock funds can concentrate in a particular continent or region (Europe, Latin America, etc.) -- in fact, it is even possible obtain a regional fund that excludes particular markets. Style in stock funds refers to the capitalization and to the method of stock selection; a stock fund can have a large, mid or small capitalization and a growth, value or blended method of stock selection. Style in bond funds refers to the length of maturity (short-term, intermediate or long-term) and to the measure of volatility (low, moderate or high). The point of all this? An investor has more fund choices than ever from which to choose -- consequently, the pursuit of diversification can sometimes be complex or overwhelming.

    The following guidelines are intended to simplify the diversification process:

    Define your investment objectives. These objectives include time horizon, return objectives, risk tolerance and portfolio amount, all of which contribute to a clear and precise focus for your investment strategy. This should be your #1 priority. If your selected funds accurately represent your objectives, then you have an effective investment plan.

    Choose quality over quantity. What is important is not how many funds you own, but how distinct they are and how they fit your investment strategy. Many investors, rather than dealing with diversification to reflect their investment objectives, sometimes view diversification as a container to be filled with as many different objects as possible; as a result, a significant portion of their portfolio could be inappropriate for their strategy.

    Avoid duplication. It is unnecessary to have multiple funds that have identical objectives. For example, owning two large-cap value funds and two small-cap growth funds in a four-fund portfolio is inefficient diversification. In general, represent a specific fund category with just one fund.

    Less is best. Use the fewest funds possible to accomplish your goals. Since most funds are comprised of 50-200 separate stock or bonds, you do not need a huge number of funds in a portfolio to achieve effective diversification.

    Normally, portfolio amount determines the number of funds in a portfolio; as portfolio size increases, more funds can be added to enhance diversification. Yet, since individual circumstances and preferences vary, one investor may be satisfied with 4-5 funds in a $100,000 portfolio, while another may prefer 7-8 funds for the same portfolio amount. However, regardless of the quantity of funds in your portfolio, the key to effective diversification is to always verify that each fund fulfills a separate and distinct purpose for your investment strategy.