Diversity Lowers Risk, Returns

With so many mutual funds on the market, investors may be tempted to keep adding to their portfolios. But how many funds do they really need?

That depends on their investment goals and their tolerance for risk, according to a study by Morningstar Inc., fund trackers in Chicago.

People who are afraid of taking a huge hit when the market tumbles may want to own as many as a dozen funds, because adding funds to a portfolio reduces risk, Morningstar analysts found. But there is a point of diminishing returns - portfolios with 30 funds are not appreciably less risky than those with 9 or 10.

Investors who are going for the gold, however, may be happier with just a handful of funds, because the diversification that dampens risk also tends to lower returns, Catherine Voss Sanders, publisher of Morningstar Investor, wrote in a recent issue.

Morningstar randomly constructed 200 portfolios holding as few as one equity fund and as many as 30, and calculated their performance over the five years ended on April 30. It assumed a beginning investment of $51,382 (chosen because that amount, invested in the average stock fund for five years, grew to $100,000).

Portfolios with just three funds returned $85,000 to $116,000, roughly $15,000 better or worse than the average fund. By contrast, portfolios holding 17 funds cut that range in half, meaning that the worst such portfolios trailed the average by less but that the best ones outperformed it by less.

Before buying new funds to add diversification, investors should consider where they will get the most bang for the buck, Voss Sanders said. Funds buying stocks of large, growth-oriented companies tend to have similar returns, while funds buying stocks of small, undervalued companies show more variation. So it makes more sense to buy several small-value funds than several big-cap growth funds.

Different rules apply for other types of assets, she said. Since there is less variance in the performance of bond funds, most investors can get by with just one well-diversified, low-cost intermediate bond fund. Investors who want more fixed-income funds can round out their portfolios with a high-yielding junk bond fund.