Magic Number May Be 4

With thousands of mutual funds investing in U.S. stocks, how many should investors own?

The answer, according to a report published by the Chicago-based research firm Morningstar Inc., seems to be four.

“If the goal is to diversify away most of the risk while preserving the chances of hitting it big, our study suggest that a four-fund portfolio might do the trick,” Catherine Voss Sanders, associate editor at Morningstar Investor, wrote in the June issue of the publication.

Some financial advisors agree that four funds is a good ball park figure, although as Morningstar also pointed out, the final number depends on how risk-averse investors are and their time frame for setting money aside.

“Four is in the range of what we tell our clients,” said Tim Medley, head of Medley & Co., a financial advisory firm in Jackson, Mississippi. “If you own only one or two funds, you are vulnerable to the fact that all good money managers have problems periodically.”

Cosmo Boyd, a partner in 680 group of Robinson-Humphrey Co. in Atlanta, says that four makes sense for diversification purposes, but that human nature might lead investors to want a few more choices in their mix.

“You have to construct enough true differences that there’s always something positive to talk about,” said Boyd. “It typically takes five to seven funds to create a horse race and give investors confidence to stick with the program.”

Morningstar arrived at the four-fund model through numbers crunching that showed the range of returns in portfolios with one, two or three funds in any given year is quite large. The difference in returns with a four-fund portfolio and a 25-fund portfolio, however, isn’t that great at all.

“The more funds, the worse the chances of making the big bucks,” wrote Sanders. If, however, investors’ biggest fear is not reaching their savings goals, more funds might be better.

Morningstar calculated that if five years ago an investor with $50,000 had a target of $100,000 today, the range of fund returns with three funds would have averaged between $85,000 and $116,000. With 17 funds, the range narrowed to between $92,000 and $108,000.