When Four Is Company
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 suggests that a four-fund portfolio might do the trick,” Catherine Voss Sanders, an associate editor of Morningstar Investor, wrote in the most recent issue of the newsletter.
Some financial advisors agree that four stock funds is a good ballpark figure, although as Morningstar also pointed out, the final number depends on how risk-averse investors are and what their time frame is 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, Miss. “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 Robinson-Humphrey Co. in Atlanta, says 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.”
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Morningstar arrived at the four-fund model through number-crunching that showed that the range of returns in portfolios with one, two or three stock 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 returns with three stock funds would have averaged between $85,000 and $116,000. With 17 stock funds, the range narrowed to between $92,000 and $108,000.
As to how to mix different categories of stock funds, Morningstar suggests that in the large-cap category, one such fund is sufficient. That’s because the differences among the returns of this style of fund are minimal.
Small-cap funds, however, tend to have greater differences in returns, meaning an investor could have more of them in a portfolio.
Although it might seem to make sense to have a range of funds from large-cap “growth” to small-cap “value,” Morningstar isn’t sure what the optimal combination is.
“We haven’t come up with a definitive answer on that,” said Pat Regnier, an associate editor at Morningstar Investor. The most important criteria, he said, are “picking good managers and low-cost funds.”
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Edward O’Neal, an assistant professor of finance at University of New Hampshire, has studied the question of whether it makes sense to own several different funds in the same investment category. In other words, if you are buying a growth stock fund, are you better off buying five growth funds? Or 20? There are more than 1,000 funds out there that call themselves growth stock funds.
O’Neal created a variety of sample portfolios of funds holding as few as one fund and as many as 30. He found that there was significant benefit in holding five funds instead of just one, and a somewhat smaller additional benefit to holding 10 funds instead of five.
The benefits, according to O’Neal, were that if you held a greater number of funds, you had a greater chance of meeting your investment goals. In technical terms, the dispersion of terminal wealth--the money that accumulated over the holding period--was greatly reduced as more funds were added, say up to 10 funds. The benefits of adding another five, 10 or 20 funds were negligible.
