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
risk/return objectives increase. The following fund categories depict different risk/reward objectives on an escalating risk
large value<large growth<mid value<mid growth<small
value<small growth<international<sector<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
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
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.