Thanks to the bombardment of financial advice people experience today, even non-experts are familiar with some common tenets of a proper planning: eliminate debt, build an emergency fund, buy life insurance and do not day trade.
All of these take a back seat to the most famous creed: Diversification. But how much is too much? How much is too little? What level of diversification is just right?
Too much diversification usually comes from the fear of losing money. The point of diversification is not to lose money, so some investors will use vehicles like mutual funds as a quick way to diversify their portfolio.
The problem comes when too many mutual funds are purchased. The reason for this is that, according to the Investment Company Act of 1940, any mutual funds cannot have more than 25 percent of its investment in one holding.
Furthermore, the other 75 percent needs to be spread out between at least 15 different securities, each staying below 5 percent of the total holdings.
This allocation could be effective with a couple of mutual funds, but when investors buy too many funds their returns could be severely watered down – especially when you add in the possible drag of investment fees.
Too little diversification comes in the guise of “overlapping.” Many investors buy mutual funds or exchange-traded funds (ETFs) without fully understanding the investments that make up the funds.
Investors are advised to spread out their money by purchasing different types of funds such as aggressive growth, growth, growth and income, income and international. This can be very misleading because how does the investor find out how many similar securities Vanguard Growth and Vanguard Growth and Income hold?
Even if you branch out and purchase a SPDR growth fund or an iShares Growth and Income, you run the chance of holding the same stocks in all these funds. To add to this problem, an “international” or “global” growth fund could consist of 40 to 50 percent of U.S. companies, adding to the overlap.
The right amount of diversification will vary by investor. This is where a knowledgeable financial planner can help.
Take the time to sit down and identify the risk tolerance and time horizon for your investment goals. Ask your planner to teach you how to research funds, so that you can take part in making sure your portfolio does not suffer from a “watering down” or “overlapping” of funds.
Luke Gawronski, a financial planner with Barnum Financial Group, is a registered representative of and offers securities, investment advisory and financial planning services through MML Investors Services, LLC. Member SIPC. firstname.lastname@example.org