One of the questions which mutual fund investors ask constantly--and tend to get wrong most often--is the number of funds one should invest in. This problem has become especially acute over the last few months as a result of two separate phenomena: one, the rise in the equity markets, and two, a wave of intensely-marketed closed end funds.
First, I must point out a more fundamental misunderstanding about what this question means. Some months back, someone asked me, in almost exactly these words, “How many funds should I invest in?”.I replied to the effect that three or four was a good enough number. At some later point, I happened to discuss that person's investment portfolio with him and I realised, much to my horror, that while I had meant a MAXIMUM of three or four funds, he had taken it mean AT LEAST three or four funds.
It was almost funny, it weren't such a widespread and harmful mistake. I guess one can't blame the logic. If zero is the most undesirable number of funds to own, and one is better than zero, then the mind just extrapolates that to the idea that the more the better. But it doesn't actually work anything like that. The reason is straightforward. The reason to invest in more funds is supposed to be diversification. However, no additional diversification is provided by investing in more funds. The reason is that the stocks held by these funds' tend to be a similar set. With a larger number of funds you are effectively adding more funds that are similar to some other fund that is already there with you.
On the downside, too many funds devalue a major attraction of investing in mutual funds, which is convenience. Keeping track of a large number of mutual funds completely negates this. At least once a quarter, such an investor would have to look at each fund's performance, give some thought to how it's doing, whether it's living up to the purpose for which it was bought. This would make sense only if some great purpose was being served, but that's not the case. The sweet spot tends to be three or four funds, anything more is a waste of effort.
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