As we were all painfully reminded last year, diversification matters. In fact, it should be an over-arching strategy of every portfolio. Though bonds and cash don't often give you sexy, double-digit returns, they can come in handy when stocks hit the skids.
For the average investor, the most cost-effective way to get diversification is through mutual funds. But how many mutual funds are enough? That is, how many do you need to hit your target asset allocation for your entire portfolio? Six? Twenty? Eighteen? Thirty?
Turns out, someone actually figured this out. According to Ibbotson Associates-- one of the most respected analytical firms in the securities industry-- all the average investor needs is ten mutual funds. (Those of you who fancy yourself mathematically-inclined can wade through the actual research paper, "Choosing Managers and Funds: How to Maximize Your Alpha Without Sacrificing Your Target, " which can be found at www.ibbotson.com. Good luck!)
Ibbotson Associates was founded by Roger Ibbotson who, along with Rex Sinquefield, announced in back in 1974 that the Dow Jones Industrial Average would hit 10,000 by November 1999. This was just 4 months after the Dow had closed out a miserable 1973 at 850. Keep in mind that from January 1973 through September 1974, the stock market had lost 42% of its value and you'll understand why most of Wall Street and the academic community thought Ibbotson had lost his marbles. However, time proved him eerily correct, albeit a trifle late. The DJIA actually closed at 10,000 on March 29th, 1999-- seven months earlier than Ibbotson & Sinquefield had predicted. (Want to know what Ibbotson is predicting for stocks over the next 20 years? Keep reading!)
OK, back to the original point of this article. According to Peng Chen, one of the research associates at Ibbotson's firm who co-authored this study, this is really a two-stage process.
The first and most important step is to determine your asset allocation-- what percentage of your total portfolio you ought to have in each asset class. This is based on your risk comfort level, time horizon and your investment goals. Easier said than done. While an variety of self-proclaimed "financial psychologists" and computer geeks have attempted to measure this and reduce it to a formula, at this point, determining your exact asset allocation is more art than science.
Once you decide upon what you think is the appropriate mix of investment classes, your next move is to select ten mutual funds that will enable you to implement this allocation. You might need as few as 7 or 8, says Chen, if you're strictly a passive (i.e. index funds only ) investor.
However, he says for the average investor, ten mutual funds will give you "a solid, diversified portfolio" and eliminate the additional hassle and cost of tracking too many funds. If you own more than 15 funds, says Chen, "you don't get any added diversification benefit." That's because the more funds you own in one asset class, the more likely you're going to end up owning a lot of the same securities. Note that this study is not saying ten funds will give you the best risk/reward trade-off for your needs and goals. That's the job of a proper
asset allocation strategy. However, once that strategy is established, ten funds are all you need to carry it out. And, according to Chen, "You don't need more than two funds in a single asset class." In other words, owning four mid-cap stock funds is not going to give you better diversification than two mid-cap stock funds.
For instance, assume you determine that you ought to have 40% of your portfolio in large-cap U.S. stocks, 15% in mid-cap U.S. stocks, 10% in small-cap U.S. stocks, 10% in foreign stocks, 20% in bonds and 5% in cash. You could put together a portfolio of ten mutual funds as follows:
In considering your allocations, you need to understand that each of these fund choices has a different risk profile. For example, growth and value stocks fall in and out of favor and fluctuate with market conditions. International investments involve certain risks, such as currency fluctuations, economic instability, and political developments. Small and mid-cap stocks are more volatile than large-cap stocks. Government securities guarantee timely payment of principal and interest, however, principal value may fluctuate with market conditions. And finally, money market funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Although money market funds sekk to maintain a constant share price of $1, it is possible to lose money by investing in such a fund.
Another word of caution: In order for your portfolio to stick to your chosen asset allocation, it's crucial that each mutual fund you select adhere to its particular investing style. This means you should weed out any funds with managers who "jump ship" and venture into another asset class just to boost the return. For instance, if your value fund manager decides to venture into (growth-oriented) biotechnology stocks because he/she thinks this is a hot area of the market, you could end up with much greater overall explosure to "growth" stocks than you want. In the words of the study, "Exclude style inconsistent managers, as style drift significantly increases the risk of not hitting the target asset allocation."
So if you're tired of getting all those quarterly statements and plowing through piles of 1099s come tax time, do yourself a favor and pare down your mutual fund holdings. And, as Chen suggests, consider concentrating your money in one fund family because most offer either reduced commissions or a higher level of service once the total value of all your accounts exceeds certain thresholds.
Here's to a simpler approach to investing!
P.S. (Are you sitting down?) In 1999, Professor Ibbotson released his latest 25-year forecast for stocks, estimating that the Dow Jones Industrial Average will cross the 100,000 mark in 2024 and close out 2025 above 120,000! So hang in there and think long-term...
I am planning to move my Roth IRA from one firm to another. My existing custodian wants to charge me $50.00 for allowing me to move MY money. Is is legal for them to charge me this fee?
Yes, such a charge is legal, provided it was disclosed to you beforehand. (And given the number of lawyers employed by securities firms, I find it nearly impossible to imagine this did not happen.) While the charge is probably not noted in the IRA Adoption Agreement you signed, information about an IRA "exit" or "close-out" fee was probably disclosed in the supplemental account materials you received when you opened your account.
Commissions and fees are usually spelled out very clearly. However, the fact that this practice is legal doesn't mean it is universal. Not every IRA custodian charges you when you close your account. Two out of the three I called told me they do not do this. The third, a nationally-recognized discount brokerage firm, does impose a fee and, like your custodian, charges $50 to liquidate an IRA.
One final point, if a firm does charge you to close your IRA, the fee might differ depending upon whether your IRA is solely invested in mutual funds, or consists of a brokerage account that can also own individual stocks and bonds.
If you have a question for Gail Buckner and the Your $ Matters column, send them to firstname.lastname@example.org along with your name and phone number.
The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.