Who Wants to Marry a Multi-mutual Fund Allocator?

By Scott Lummer
Chief Investment Officer, mPower

Some of you have written in saying that my responses to questions are very predictable. I'm always warning about taking too much risk and preaching broad diversification. This week's question is for you:

"Dear Scott: I am very diversified, with 45 different funds for investment. Is this too many, and would it be better to move into a few less?"

There is such a thing as too much diversification. I have a general rule of thumb: if you have more mutual funds than my daughter has beanie babies, then you have way too many.

Your situation is definitely a case of "less is more"

Let me talk about what I see as the ideal way to allocate across funds, and then describe what's wrong with choosing too many funds.

First of all, divide your money into three broad categories:

• U.S. stocks
• International stocks
• U.S. bonds

For U.S. stocks, I use large company growth, large company value, small company growth, and small company value.

For the international market, I use developed country and emerging market stocks.

And for bonds, I use money market and short-term bonds (for the reasons why I don't use other types of bonds, see my earlier column.

At the end of this exercise, I have eight elite groups.

There is, however, flexibility about how many groups you may want to use. For example, you may not want to divide the international group at all, or you may want to divide it into several small sectors. Just realize that each time you make a sub-division, you force yourself to make one more allocation decision.

Decisions, decisions

If, for example, you decide to divide international stocks into northern and southern European regions, you must make an explicit allocation decision about how to divide your investment between them. That's why I think eight is enough -- it provides useful diversification while allowing simplicity of decisions.

Now here is the key to the elite eight:

Choose only one fund per group. Anything more is a waste of resources.

Find a fund that has a philosophy you believe in, displays a reasonable track record, and does not over-weight any individual stocks or industries. But choose only one fund. If you really feel you must, go ahead and pick two -- but no more than two!

The law of large numbers

Now, here's the reason you don't want to choose too many funds: it's a statistical property called the "law of large numbers." If you believe that you can choose funds that have above-average return performance, then you will be selecting "actively managed" funds -- funds that pick individual stocks in an attempt to beat the average return. Active funds have expenses associated with them because they hire experienced managers and analysts, and pay commissions when they buy and sell securities.

If you pick a single active fund, you do so because you think its average return will outperform its expenses.

You may think that if picking one active fund in a group is good, then picking two is even better. But no more than half of the funds in a group can do better than the average.

That's the law of large numbers.

Some funds will beat the average, and some will lag behind. The more funds you choose, the more likely the returns of the funds will balance out. Indeed, one of the funds you own may be buying the stocks another one of your funds is selling.

Eventually, you will force the overall performance of those funds to move toward the average. However, you will be incurring the expenses of those active funds.

Is your fund a good match?

You don't have to pick active funds; you can pick index funds -- funds that try to match average performance of an index as inexpensively as possible. Average index fund expenses are cheaper than those of typical active funds, because they trade less and do not employ securities analysts.

Before joining mPower, I used to work as a consultant advising large pension plans and other institutional funds on their investments. One of my pension clients used over 200 separate funds! When I asked why they didn't simply choose index accounts, they told me it was because they believed they could choose funds that did better than the index. Yet when I analyzed the past performance of the pension plan, it behaved almost precisely like the index, except for the expenses that it incurred.

Collectively, the different funds' performance cancelled out the returns of each individual fund. Consequently, they, and you, would be much better just choosing an index fund, which would give you that average return more cheaply.

It's kind of like placing a bet on the Super Bowl. If you thought the Rams would win, you might bet on them. If you thought the Titans would win, you would consider betting on them. But it would not make sense to bet on both of them -- your bets would cancel each other out and you would be left paying the "expenses" to a Las Vegas bookmaker. It would be better to not bet and just to watch the overly produced, non-memorable commercials.

Avoid annulments -- wise allocation choices

You basically have three choices when deciding how to invest within a group. You can use an index fund, a single active fund, or many active funds. What I am saying is that using many active funds will always produce poorer returns than choosing an index fund. Of course, this begs the question of whether you should use an index fund or an active fund, but that is a topic for another column.

If you're annoyed that I'm not answering that question here, just consider it a return to predictability.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Who Wants to Marry a Multi-mutual Fund Allocator?

By Scott Lummer
Chief Investment Officer, mPower

Some of you have written in saying that my responses to questions are very predictable. I'm always warning about taking too much risk and preaching broad diversification. This week's question is for you:

"Dear Scott: I am very diversified, with 45 different funds for investment. Is this too many, and would it be better to move into a few less?"

There is such a thing as too much diversification. I have a general rule of thumb: if you have more mutual funds than my daughter has beanie babies, then you have way too many.

Your situation is definitely a case of "less is more"

Let me talk about what I see as the ideal way to allocate across funds, and then describe what's wrong with choosing too many funds.

First of all, divide your money into three broad categories:

• U.S. stocks
• International stocks
• U.S. bonds

For U.S. stocks, I use large company growth, large company value, small company growth, and small company value.

For the international market, I use developed country and emerging market stocks.

And for bonds, I use money market and short-term bonds (for the reasons why I don't use other types of bonds, see my earlier column.

At the end of this exercise, I have eight elite groups.

There is, however, flexibility about how many groups you may want to use. For example, you may not want to divide the international group at all, or you may want to divide it into several small sectors. Just realize that each time you make a sub-division, you force yourself to make one more allocation decision.

Decisions, decisions

If, for example, you decide to divide international stocks into northern and southern European regions, you must make an explicit allocation decision about how to divide your investment between them. That's why I think eight is enough -- it provides useful diversification while allowing simplicity of decisions.

Now here is the key to the elite eight:

Choose only one fund per group. Anything more is a waste of resources.

Find a fund that has a philosophy you believe in, displays a reasonable track record, and does not over-weight any individual stocks or industries. But choose only one fund. If you really feel you must, go ahead and pick two -- but no more than two!

The law of large numbers

Now, here's the reason you don't want to choose too many funds: it's a statistical property called the "law of large numbers." If you believe that you can choose funds that have above-average return performance, then you will be selecting "actively managed" funds -- funds that pick individual stocks in an attempt to beat the average return. Active funds have expenses associated with them because they hire experienced managers and analysts, and pay commissions when they buy and sell securities.

If you pick a single active fund, you do so because you think its average return will outperform its expenses.

You may think that if picking one active fund in a group is good, then picking two is even better. But no more than half of the funds in a group can do better than the average.

That's the law of large numbers.

Some funds will beat the average, and some will lag behind. The more funds you choose, the more likely the returns of the funds will balance out. Indeed, one of the funds you own may be buying the stocks another one of your funds is selling.

Eventually, you will force the overall performance of those funds to move toward the average. However, you will be incurring the expenses of those active funds.

Is your fund a good match?

You don't have to pick active funds; you can pick index funds -- funds that try to match average performance of an index as inexpensively as possible. Average index fund expenses are cheaper than those of typical active funds, because they trade less and do not employ securities analysts.

Before joining mPower, I used to work as a consultant advising large pension plans and other institutional funds on their investments. One of my pension clients used over 200 separate funds! When I asked why they didn't simply choose index accounts, they told me it was because they believed they could choose funds that did better than the index. Yet when I analyzed the past performance of the pension plan, it behaved almost precisely like the index, except for the expenses that it incurred.

Collectively, the different funds' performance cancelled out the returns of each individual fund. Consequently, they, and you, would be much better just choosing an index fund, which would give you that average return more cheaply.

It's kind of like placing a bet on the Super Bowl. If you thought the Rams would win, you might bet on them. If you thought the Titans would win, you would consider betting on them. But it would not make sense to bet on both of them -- your bets would cancel each other out and you would be left paying the "expenses" to a Las Vegas bookmaker. It would be better to not bet and just to watch the overly produced, non-memorable commercials.

Avoid annulments -- wise allocation choices

You basically have three choices when deciding how to invest within a group. You can use an index fund, a single active fund, or many active funds. What I am saying is that using many active funds will always produce poorer returns than choosing an index fund. Of course, this begs the question of whether you should use an index fund or an active fund, but that is a topic for another column.

If you're annoyed that I'm not answering that question here, just consider it a return to predictability.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.