|
Diversity in the fund jungle
|
 |
June 18, 1998: 4:09 p.m. ET
Diversifying your funds can reduce risk but can also hold returns in check
|
NEW YORK (CNNfn) - In the animal kingdom, diversity is everything. But in the mutual fund jungle, diversification does not necessarily guarantee survival.
Mutual fund diversification, the number of different types of funds you hold in your portfolio, is a key concern for many investors.
Too little diversity, they fear, and their investments could be pounced on and devoured by market volatility. Too much diversity, and they might be more secure but miss out on a chance to rule the forest.
Unfortunately, there's no easy answer as to how many funds you should own, said Matthew Peterson, vice president of investment management at CMS Financial Services.
"You can hold two funds and be overdiversified. You can hold 10 funds and be fine," he said.
The struggle over fund diversification often becomes a battle between equity funds, which invest in stocks, and fixed income funds, which usually invest in bonds.
Age can play a factor in your decision. Someone who is 25 years old can probably hold more of their money in equity funds than can a 60 year-old since the younger person's market risk will even out over time. An older person could have his investments wiped out by market volatility just as he is hitting retirement.
Some financial planners cite a standard formula for figuring out how much of each type of fund you should hold: 100 minus your age equals stock fund percentage. Therefore, a 30 year old would have 70 percent of their money in such investments.
However, like any formula, this can fail when it hits the real world. Even if you accept the formula as a baseline, you are still faced with a myriad of choices for that 70 percent. Do you put it in aggressive emerging market or technology funds or more reliable large-cap funds?
What are you afraid of?
Ideally, your mutual fund diversification allocates your portfolio around to different types of funds to not only achieve your reward objectives but also to reduce your overall risk.
But risk is different for everyone. Some of us are tigers. Some of us are sloths.
"You need to first figure out what it is you're afraid of," said Catherine Voss Sanders, publisher of the Morningstar Fund Investor. "Is it losing 10 percent in one month or missing out on the jackpot if the market soars?"
You'll also need to consider a variety of factors which are specific to your goals. Jack Piazza, managing principal at Sensible Investment Strategies, urges investors to identify their investment position. This could include:
- Portfolio size (how much you have to invest)
- Return objectives (growth, balanced or income-oriented)
- Time horizon
- Risk tolerance
Once you've got your plan set, then you can go out and hunt down the right mutual funds for you. However, don't let the current bull market necessarily push you into overweighting your investments into high-risk non-diversified holdings.
"This is one of the biggest mistakes I see in portfolios," said Piazza.
Core holdings, he said, should consist of large-cap growth funds, growth and income funds and equity income funds, depending on your risk tolerance.
As your portfolio increases, you can add international funds, small-cap and mid-cap funds to increase your diversity.
The important thing is not to get hung up on holding a specific number of funds. "Numbers don't necessarily diversify you," said Sanders.
Morningstar's research shows that increasing the number of funds in your portfolio decreases your risk up to a point. Four funds are safer than one fund, but adding 20 more funds has a negligible effect on the safety of your investments.
Increasing your fund holdings has another effect over the long term; it narrows the range of how much you'll make off your investments.
For example, the average investor who starts with $50,000 ends up with $100,000 five years later based on the average domestic stock fund return for the past five years.
Investors with three funds in their portfolio will average a return of between $85,000 and $116,000, a range of about $15,000 on either side of the $100,000 benchmark. If they increased their holdings to 17 funds, that $15,000 range is narrowed by half.
No escape from risk
The more risk-averse can't necessarily squirrel away the majority of their money in fixed-income funds and expect to be totally free from the danger of market volatility either.
"Fixed-income returns, after taxes and inflation, tend to be very low," said CMS' Peterson. "If you're under 45, I'm not sure you should even hold bonds."
Peterson often urges those clients who do want to keep some of their investments in bonds to look at ultrashort-term bond funds. These funds, such as the Strong Advantage fund (STADX), invest in bonds whose maturities do not exceed one year.
When diversifying between funds (for instance, holding two growth funds) keep in mind that the objectives of a fund are more important than the style, said Piazza.
Large-cap funds include growth, growth and income, and equity income fund styles, yet each of these offer distinct return objectives.
Additionally, not all fund styles lend themselves to diversity. Indexed funds are pegged to a specific benchmark so there is basically no benefit to holding more than one.
Other funds, however, offer a much wider latitude. There are many more small companies than large ones, so there are a wider range of small-cap fund choices with less investment overlap (two funds investing in the same stock).
In the end, you'll need to have confidence in your initial plan. Financial planners bemoan the fact that often their clients will chase the fund style or sector, such as Europe funds, which happen to be hot at the moment.
If you've talked it over with your investment professional and she agrees your plan is basically sound, you should maintain that systematic method of fund diversification.
When things change, you don't necessarily need to swap an emerging markets fund for a technology fund. Instead, you may want to just move into another emerging market fund.
"Life events may force you to rethink that plan," said Peterson. "Don't rethink your plan based on what's happening on the market."
-- by staff writer Randall J. Schultz
|
|
|
|
|
 |
|
