Most investors understand that having a diversified portfolio with many different types of investments can help reduce your overall investing risk. But many investors fail to consider that owning several mutual funds doesn't necessarily mean that you're more diversified than you would be with just a single fund.
In his book Think, Act, and Invest Like Warren Buffett, stock-market researcher Larry Swedroe notes that mutual fund investors mistakenly believe that it's the number of different mutual funds they own that defines how diversified their investments are. Yet, as Swedroe points out, owning 10 actively managed funds that all focus on U.S. large-cap stocks can leave you with the same stock market exposure as a single low-cost index fund -- while incurring much higher costs in the bargain.
When Different Funds Aren't Worth It
Mutual fund managers have only a limited universe of stocks to consider for their portfolios, with the fund's investment objective defining where the managers need to focus their attention. Although some funds give managers a limited amount of latitude to go beyond their primary objective, managers who stray too far from that objective run the risk of making investors unhappy with their performance -- especially if the choices they make end up costing fund shareholders money.
As a result, with large-cap mutual funds mostly looking at just a few hundred candidates for investment, owning more than a few will leave you with what adds up to holdings that look quite similar to an index fund.
Take a look at some of the largest stock mutual funds in the U.S. market and the portions of their portfolios they have in their biggest holdings:
Add all those holdings together, and you'll see just about all of them included within the bargain-basement S&P index fund Vanguard 500 Index (VFINX). Four of them -- Exxon, Chevron, Google, and Pfizer -- show up in the index fund's top 10 holdings.
How to Truly Diversify Your Fund Portfolio
To get more diversified, it's not enough to own a bunch of funds. You have to own a bunch of different kinds of funds. In particular, aim to include a mix of funds covering these broad categories:
For stocks, most funds focus on large U.S. companies. So be sure to add some exposure to smaller domestic stocks, as well as international stocks of all sizes. On the international front, you can find mutual funds that cover companies throughout the world, or you can narrow your focus on particular areas like emerging markets or specific geographical regions.
The same rule applies to bond mutual funds. Although different parts of the bond market often move in similar directions, the behavior of Treasury bonds, tax-free municipal bonds, and corporate bonds can produce very different returns. Also, make sure you're comfortable with the time horizon of the bonds your mutual fund owns; longer bonds can have better yields but also carry greater risk of falling prices when interest rates rise, as they have recently.
Finally, consider mutual funds outside the traditional stock and bond arena. Mutual funds focusing on real estate, commodities, and other nontraditional asset classes will broaden your entire portfolio.
Don't make the mistake of thinking that having an impressive list of mutual funds adds to your overall diversification. More often than not, all it does is leave you no better diversified than you would be with the most basic index fund.
Motley Fool contributor Dan Caplinger owns shares of Apple, Berkshire Hathaway, and Washington Mutual Investors Fund, as well as warrants on Wells Fargo. The Motley Fool recommends Amazon.com, Apple, Chevron, Gilead Sciences, Google, Home Depot, and Wells Fargo. The Motley Fool owns shares of Amazon.com, Apple, Google, and Wells Fargo.