By Peter Mastrantuono
Diversification is a good thing. Nevertheless, too much of a good thing can be bad. Owning too many mutual funds in your 401(k), for example, may mean you’ve accomplished nothing more than simply mimicking an index fund but with much higher fees. Over diversified portfolios also may result in overlapping holdings that subject you to investment risks you can’t see.
Moreover, owning too many mutual funds makes difficult to properly monitor a portfolio’s performance and easily rebalance fund holdings to your original target asset allocation.
Finally, what many investors (professionals included) fail to appreciate is that the performance of small-percentage holdings generally has little impact on the value of your portfolio—a 25% return on a 1% holding increases your portfolio by 0.25%. That seems hardly worth the trouble of researching, tracking, and managing such a small investment position.
Determining the Optimal Number of Funds
There is no single right answer to the question “What is the optimal number of mutual funds to hold in my 401(k)?”
The answer depends on a number of factors, including your desired asset allocation and the level of involvement you want in managing your portfolio.
The asset allocation you create will be based on your risk tolerance, investment objective and time horizon. It will also be dictated by the number of asset classes in which you wish to invest, e.g., “yes” to alternative investments, “no” to emerging market bonds. Remember, your asset class exposures may be restricted by what funds are made available in your 401(k). Developing an asset allocation and choosing what asset classes to include is something your financial advisor can be very helpful with doing.
The second factor relates to how much involvement you want in managing your 401(k) investments. Many individuals prefer to keep it simple, in which case one or two funds may be sufficient. Those preferring little involvement can choose to select an appropriate target date fund or pick a couple of broadly diversified index mutual funds (e.g., an all-U.S. or all-World stock fund and a bond index fund based on the Bloomberg Barclays Aggregate Bond Index).
For investors who prefer to be more precise in their exposures to different asset classes (e.g., large cap, small cap, mid cap, international, etc.) more funds may be appropriate.
While the number of funds will be predicated on the range of asset classes and investment styles (value, growth, blend) you want in your 401(k), the optimal number may be as low as four (U.S. equity fund, U.S. bond fund, international stock fund, international bond fund) to as many as 10 or more.
Many financial advisors believe that 10-12 funds may be enough to give you broad diversification across a wide range of asset classes. Other advisors think the optimal number may go as high as 20.
We return to where we started: There is no one correct answer to how many funds define an optimal number. However, by working with a financial advisor and sharing your goals and investment preferences, he or she will be able to help you design an effective investment strategy and select the funds to meet your investment objectives and preferences.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.
