Diversify, But Not Too Much
If you are among the few super-disciplined mutual-fund investors who actually do re-evaluate and adjust your portfolios at the end of the year, consider this: Are you “over”-diversified?
Huh? Isn’t diversification a good thing?
In general, yes - but only if you go about it in a deliberate way. Diversification spreads your risk, so you don’t get hammered by being concentrated in, say, small-stock or technology funds, when they head south. On the other hand, diversification can also lower your return, since the losers can neutralize the winners.
If you are widely diversified, owning, say, a dozen mutual funds, you’re spreading your investment around among hundreds or even thousands of stocks. Your portfolio as a whole thus mirrors the stock market, and the best you can expect is to match the performance of the market.
There’s nothing wrong with that, but if you’re going to invest in the whole market you might as well do it through an index fund. That way, you’ll enjoy the low fees and expenses of index funds. If you are, in effect, doing index investing, there’s no good reason to pay a fund manager and research staff.
Over-diversification can creep into a portfolio unexpectedly. Many of us fall into this by selecting new funds as new savings become available. The old funds stay in the portfolio because you’re used to them, they’ve done well, you expect them to turn around, or you can’t face the tax hassle that follows when you move the money elsewhere.
Better to take a hard look at your funds and get out of those that are not performing the way you expect them to. Now is a good time, especially if you have losers that can help reduce your 1996 taxes.
How many funds should you have? A good rule of thumb is to have no more than three diversified domestic stock funds, says G. Richmond McFarland, director of mutual fund adviser services for Widmann, Siff & Co. If you have more than three diversified funds, you’d be better off with an index fund, he says.
Note that McFarland uses the term “diversified” domestic funds, meaning funds that buy a large number of stocks in a wide range of industries. The three-fund guideline would not include narrowly focused, specialized funds, such as those that invest in health-care or financial companies.