How Many Funds Do You Need?

Key Points

» The Purpose of Mutual Funds
» Why Hold More Than One Fund?
» Fund Investment Categories
» How Many Funds Are Right for You?
» How Many Is Too Many?
» Time to Reevaluate
» Points to remember

When you sit down to evaluate your portfolio, do you have trouble
remembering exactly why you bought certain funds in the first
place? Do you buy funds randomly, based on recent magazine or
newspaper articles? If you answered yes to either of these
questions, you may be guilty of fund collecting.

The Purpose of Mutual Funds 

Mutual funds are pools of securities, which typically offer
diversification within one or more asset classes. In general,
people invest in mutual funds in order to achieve diversification
in their portfolio without the trouble of managing a large number
of stocks and bonds. With thousands of mutual funds available
today, however, some people have started collecting mutual funds as
if they were art. The downside of holding too many similar funds is
potentially lower returns on your portfolio.

Why Hold More Than One Fund? 

The number that is right for you depends on your investment goals,
risk tolerance, and the amount of your investment capital. If you
have both short- and long-term goals, you will likely want
different types of mutual funds for each time frame. The more
capital you have to invest, the greater your ability to afford
diversification among different asset classes and investment
styles.

Asset allocation is the way you weight investments in your
portfolio. There are three main asset classes: stocks, bonds, and
money market securities. Each has its own characteristics in terms
of value fluctuation, level of market risk, and ability to outpace
inflation. Which asset classes you decide to invest in depends on
how your investment time frame and goals match up with the risks
and return potential of the various asset classes.

The concept of diversification — the process of investing in
different types of funds or securities in order to reduce risk
— is an important part of asset allocation. Diversifying among
different asset classes increases the chance that as one investment
is falling in value, another may be rising. A mix of assets will
help position your portfolio to benefit during market upswings,
while suffering less during downturns. Keep in mind that there is
no guarantee that a diversified portfolio will enhance overall
returns or outperform a nondiversified portfolio. Diversification
does not ensure against market risk.

If you have sufficient capital, you can also diversify among
investment styles to help reduce risk. Active and passive investing
are the two most basic investment styles. While active investors
believe that managed funds have the ability to outperform the
market, passive investors have faith in the long-term success of
the market index. Active investors are further divided into the two
categories of growth and value. Growth funds typically invest in
well-established companies with strong earnings potential. Value
funds, on the other hand, invest in companies that have recently
fallen out of favor but are expected to bounce back. Many investors
prefer to combine investment styles to potentially gain through
different market cycles that favor different approaches.

Fund Investment Categories

Balanced– These funds use a mix of stocks, bonds, and money market securities to try to generate moderate growth and income while carrying moderate risk. Bond– Invests in government, Treasury, and municipal bonds to provide revenue and reduce market risk. Global– Invests in foreign securities seeking to balance out single market performance risk. May include a percentage of domestic holdings. Growth– Actively buys and sells stocks in an attempt to generate high returns. May use high-yield bonds or mortgage derivatives. Carries higher market risk than other fund types. Index– Strives to post returns comparable to benchmark index for investment category. Risk varies with asset class. Money market1– Invests in high-quality bonds, commercial paper, and bank notes. Seeks to maintain a stable share price and generate income. Carries a low market risk but lower returns are highly susceptible to inflation risk. Small-cap– Buys and sells stocks of smaller companies in search of high returns. Many of these funds are aggressive growth funds and carry higher risk. Large-cap– These growth funds buy and sell stocks of larger, well-established companies in search of high returns and a lower degree of volatility. Value– Seeks to maintain principal and generate modest income by investing in out-of-favor or undervalued securities. Low annual returns may not outpace inflation. 1An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.

How Many Funds Are Right for You? 

Consider investing in a minimum of three mutual funds. These first
funds would likely include a stock fund, a bond fund, and a money
market fund. How much you invest in each fund will depend on your
investment goals, risk tolerance, and time horizon.

You might want to consider adding a mix of different types of stock
and bond funds to further diversify your portfolio. A long-term
investor seeking growth who already holds a domestic large-cap
stock fund, for example, could add a small-cap stock fund and an
international stock fund without duplicating holdings.

How Many Is Too Many? 

With so many funds in the market, it is inevitable that there are
several funds with similar strategies and performance. These funds
invest in the same stocks and follow identical investment styles.
If you hold several funds that all use similar investment
strategies in your portfolio, you essentially hold the market. You
could achieve the same result much more cost-effectively by simply
buying an index fund.

Time to Reevaluate 

Each fund that you invest in should play a specific, defined role
in your portfolio. An investment advisor can help you evaluate each
fund and its role in your portfolio. If you find yourself
surrounded by a sea of similar funds, or can’t remember why
you bought a fund in the first place, it could be time to pare down
your portfolio.

Points to Remember 

1. People invest in mutual funds in order to achieve
   diversification without the time and cost of tracking hundreds of
   individual securities.
2. There is no ideal number of mutual funds to own.
3. Before picking a mutual fund, consider your investment goals,
   time frame, and amount of investment capital.
4. Diversify among different asset classes to help reduce risk and
   potentially increase the rate of return of your portfolio.
5. Owning too many funds means you may be paying for active
   management when you really hold the market.
6. Your investment advisor can help you evaluate each fund to
   determine its role in your portfolio.

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