"Diversify!" we say, and most of the individual investors I've seen seem have listened. For years brokers, financial planners and online experts have been saying that you need to have a healthy blend of different stocks, bonds and funds to invest successfully. Unfortunately, we do not seem to have done such a good job of explaining how many investments there are in a "healthy blend." I know this because I continue to see new clients walk in with respectable little investment accounts broken up into enough funds to choke a stockbroker. So how many investments do you really need?
Let's start with this fact—the whole reason that mutual funds were invented was to make diversification easy. The fund itself is meant to be an instant portfolio, a mix of different stocks or bonds that you can buy all at once instead of in a hundred different purchases. So, the easy answer to "how many funds do I need?" is often just, "one."
But, of course, there are different kinds of diversification. Buying a little Apple, a little Expedia and a little Home Depot stock will give you some diversification in that, if one goes down, the others might not. But Apple, Expedia and Home Depot stocks all have something in common—they are are all U.S.-based companies with large market capitalization (called "large cap" stocks, it means they have more than $10 billion invested in them). And we've noticed that stock markets being what they are, when people sell off one U.S. large cap stock, they often sell off a lot of others like it.
Because of this, we have a second kind of diversification—you don't just mix the stocks themselves, but also the kind of stocks...or bonds, or REIT's or other investments. This earlier post on asset allocation talks about the different asset classes we use for this kind of diversification. As much as we in the investment industry like to complicate things, most investment accounts don't need more than five or six funds to be fully diversified. Many accounts don't even need that many. A single target date fund is an easy way to hit the basics, and a simple trio of U.S. stock fund, bond fund and non-U.S. stock funds is an easy and very respectable solution for a basic investment account.
So what is the problem with being over-diversified?
The biggest problem with having too many investments in your account (aside from the mile-long quarterly statements) is that you are likely to fall into a common trap—un-diversifying your account. By this I mean that too many investors put their money into such a complex array of funds that they don't realize how many of those investments are actually the same. It's no wonder when we look at the fund names. I mean, really, what is an "advantage" fund supposed to be? How about a "blended style fund"? A "new perspective growth fund"? It's no wonder people end up choosing randomly and hoping for the best. But more often than not, this ends in a portfolio that looks diverse from afar but turns out to be a lot of different funds all holding basically the same stocks (most often, the U.S. large cap list). If you aren't going to consult with a financial planner, the only solution to this is to do your homework on what those funds really are.
There is one more kind of diversification.
So far, I've talked about simple diversification and asset allocation, but there is one more, really important type of diversification. And that's a diversification that takes into account what is outside your investment accounts. If you work for Software Company X, and more than 50% of your investment account is in similar tech companies, you should probably think about the effect a downturn in the industry might have on your finances. Likewise, if you've got most of your savings tied up in a small business venture with your cousin or a real estate venture with your best friend from college, think twice about going heavy on similar investments in your account. Your investment account is part of a much larger strategy for creating income and protecting savings. It needs to work alongside all the other resources in your life. And that might mean fewer investments in the account to balance out whatever you have going on outside the account.
Simple and Growing.
Sometimes diversification is a process, especially if you have a small account but are regularly adding to it. Don't be afraid to start with one or two asset classes that are selling at a lower price right now and then add in, say, a mid-cap stock fund or an international stock fund later. Just be sure you know the asset classes or investments types you want to have and try to limit yourself to one fund for each of them as you grow, even if that means starting with a single fund. In the end, the greatest challenge in investing isn't that complicated—make sure you have a good strategy and stick with it as you build. Investing can be difficult but that doesn't mean it has to be complicated.