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How much diversification is ideal in a mutual fund?

CAn a mutual fund be too big/too diversified?

May 22, 2012 by Jasper from Monroe, LA in  |  Flag
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5 votes

Yes and no.

If mutual fund managers believe they can beat the market, yes a fund can be too big/diversified. Active managers who try to beat the market close their funds from time to time because they cannot invest without making an unfavorable impact (make prices rise too much before completing the entire purchase). If they believe they can beat the market, they do not want to be diversified because their stock choices theoretically will outperform the rest of the market.

On the other hand if fund managers believe they cannot consistently beat the market, then they will manage funds passively such as indexing. A larger fund will spread management costs over more investors thereby reducing the cost for each investor so they can not be too big.

What are the practical implications of this ambiguity? Actively managed funds have higher costs. Whether their performance recoups those costs over the long term is the question. For most sectors, over long periods, passively managed funds outperform. For actively managed funds who outperform, ask whether it was due to skill or luck. If skill, can you identify the fund manager before the outperformance? Hope this helps.

Comment   |  Flag   |  May 22, 2012 from Ridgefield, CT

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1 vote

Not as long as it is properly diversified.

Comment   |  Flag   |  May 22, 2012 from Cleveland, OH

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Paul and Jeffrey are right.

It depends on why you're seeking diversification. Risk mitigation?

Something many individual investors don't think about is exactly what risk they're trying to protect against. You can mitigate business risk (the risk that one stock will suffer due to business issues)through diversification; but, what many don't realize is that you can't diversify away market risk.

That may sound counter to what you've heard; but when you think about it, it becomes clear. For example, if you buy a mutual fund that invests in only one sector, you may have risk that's greater than the broad market. If you add funds in other sectors, you can possibly reduce your risk somewhat; but if you purchased a fund that was diversified throughout the entire market, you likely wouldn't be reducing market risk, you'd be replicating it!

So, the more diversified your fund is, the more likely you'll be replicating market risk, rather than reducing it. Risk reduction might better be accomplished by allocating assets across multiple asset classes - stocks, bonds, commodities, real estate, and cash - all of which can be done via fund investing. Then it's not a matter of being too diversified, as much as being properly diversified, as Jeffrey says. Good luck!

Comment   |  Flag   |  May 23, 2012 from Moorpark, CA

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