My wife has eight mutual funds in her 401(k) account. I realize that it's good to be diversified, but is this overkill?
QUESTION: My wife has a 401(k) account through her employer. Recently I noticed that she had money in eight separate mutual funds. I realize that it's good to be diversified, but we're only talking about $60,000. Her account adviser told her that she needed that amount of diversity. Does this sound normal to you?
ANSWER: Eight funds may sound like a lot to you, but that number didn't set off any alarm bells with our experts. While there are no hard-and-fast rules on this issue, four to 10 funds is the consensus range for a healthy portfolio. That said, the point of having several funds is diversification. And whether your wife's portfolio achieves that depends, of course, on just which funds she has selected. "One could choose a half-dozen funds that all do the same thing," points out Don Cassidy, senior research analyst at fund-tracking firm Lipper.
Obviously, six large-cap growth funds won't offer her any protection in a down market. But a diversified portfolio should. In one study, the folks at fund-tracker Morningstar computed the risks of portfolios containing from one fund up to 30. They found that a single-fund portfolio gives you the highest standard deviation, which means it offers both the highest possible risk and return. (Standard deviation measures the range of a fund's performance; the wider the range, the more potential for volatility.) Add one or two funds and that volatility drops off significantly, but those decreases grow markedly smaller as you move from four to seven funds. "After 10 funds, it's just noise," says Peter Di Teresa, senior analyst at Morningstar. After all, if you add too many funds, what you've got is an index — and if that's what you want, a far cheaper option is to simply buy a few index funds.
Still, different experts have different limits. Twelve funds is the ceiling for certified financial planner Dee Lee, based in Harvard, Mass. Overall, though, Lee prefers what she calls the "six-pack" approach: For most investors, she figures, holding six funds allows them to invest enough in each fund to get the full impact of its performance.
No matter how many funds you buy, it's critical to make sure that you're not duplicating your efforts — even if you have a spartan portfolio of just a few funds. Likewise, your wife's holdings should probably be viewed in context of the other funds held outside her 401(k). For example, if you're also contributing to a 401(k), you and your wife might want to make sure that you don't have too much overlap between funds.
To examine an existing portfolio, break it into several parts, such as U.S., international and fixed income. If your wife has more than one fund in each group, check to see if their holdings overlap in terms of style (growth or value) as well as market-cap size (small cap, midcap and large cap). Using the overlap meter on our fund snapshots, you can compare the top 10 holdings of two funds. Alternatively, you could simply examine a fund's investment objective — found in its prospectus — and make sure that it doesn't closely match that of any other picks.
Your wife should also check that she has the appropriate amount invested in each fund. One way to do that is to consult our asset allocator. "No one fund should hold too large a portion of your entire portfolio," says Ramy Shaalan, senior fund analyst at fund tracker Wiesenberger, "and yet each percentage allocation should be a proxy of the investor's investment objective and preferences." If growth is your main objective, allocate a greater portion of your money to funds that pursue the same goal.
The same guidelines apply to taxable investments, but keep in mind that fund companies typically require higher initial investments in taxable accounts — so you'll have to cough up a lot of big minimums to invest in a lot of different funds. Plus, if you manage your own portfolio — vs. employing an adviser — more funds means more paperwork to handle. For each fund you'll receive annual and semiannual reports, as well as periodic statements and proxies — a blizzard of paper if you have a dozen funds.