Stingy Investor Contact - Subscribe - Login
  Home | Articles | Screens | Links | SNW | Rothery Report
 
Dangerous Diversification

Investors are constantly told to diversify, diversify, diversify. The main reason to diversify is to prevent catastrophic losses. If structured properly then diversification may also allow for increased returns with a lower level of portfolio fluctuation. These benefits sound great but diversification is mainly a stock concept and can be dangerous when applied to fund portfolios. Mutual fund diversification can quickly get out of hand and wind up costing investors a lot of money.

Most equity mutual funds hold anywhere from twenty to over one hundred stocks with the average fund owning about fifty. From a stock point of view, fifty stocks should provide most investors with an adequate level of diversification. A two-fund portfolio could represent ownership of over 100 stocks. Owning 100 stocks may not seem to be much of a problem but I've seen fund portfolios that contain more than twenty funds. A twenty-fund portfolio could translate into owning an interest in over 1,000 stocks. At this point the massively diversified fund investor owns an interest in so many stocks that their portfolio starts to look remarkably like a broadly based index fund.

Consider that the U.S. based S&P500, which is composed of 500 stocks, provides good coverage of U.S. blue-chip stocks. In Canada the pickings are slimmer and the equivalent blue-chip index is the S&P/TSX60 which contains only sixty stocks. By owning too many funds an investor can quickly wind up owning a portfolio that is very similar to an index fund. All at many times the cost.

Let's look at a small fund portfolio with equal amounts of the Spectrum Canadian Equity fund and the Elliott & Page Equity fund. Both funds try to beat the market by investing in large Canadian companies. In other words, they'll both be buying stocks in the S&P/TSX60.

The Spectrum Canadian Equity fund held sixty-three Canadian stocks at the end of March and charges a MER of 2.57%. The Elliott & Page Equity fund held thirty-eight Canadian stocks and charges a MER of 2.45%. By buying equal amounts of both funds you would hold an interest in 52 out of the 60 stocks in the S&P/TSX60 index. That's over 86% of the index. Sure there are some differences. For instance, the index doesn't hold exactly the same amount of each stock as the fund combination. But even at two funds there is a considerable amount of overlap.

Think about how much worse the situation would get if you added just one more Canadian equity fund to the mix.

Now let's look at the costs involved. Investors can easily buy a low-cost S&P/TSX60 index fund. In this case, the XIU exchange-traded fund (ETF) listed on the TSX would be suitable. ETFs trade just like stocks but are otherwise very similar to index funds. The main advantage of the XIU ETF is its modest MER of 0.17%. On the other hand, the equal combination the Spectrum and Elliott & Page funds would have an effective MER of 2.51%. The fund combination is over 14 times more expensive than the index. That's 14 times the cost to buy a very similar collection of stocks. The two-fund solution is clearly unattractive and is a simple case of selecting too many expensive funds.

For Canadian equity funds I suggest sticking to a maximum of one fund for large stocks and one fund for small stocks. The larger U.S. market can accommodate more funds but I'd still stick to a maximum of two large company funds and two smaller company funds. In general, a fund portfolio that holds more than ten mutual funds probably suffers from over diversification.

Naturally one can go for a combined 'core and explore' approach. Here the investor holds index funds as the 'core' of their portfolio and one or two actively managed funds for 'exploration'. Either way, both index funds and actively managed funds should be selected primarily on the basis of cost. Low-cost funds help investors to improve the odds of building a winning portfolio.

First published in September 2002.

  MoneySense Articles
 Cdn Top 200 2016
 US Top 500 2016
 Retirement 100: 2015
 Cdn Top 200 2015
 US Top 500 2015
 Retirement 100: 2014
 Cdn Top 200 2014
 US Top 500 2014
 Retirement 100: 2013
 Cdn Top 200 2013
 US Top 500 2013
 Retirement 100: 2012
 Buffett Buys
 FB IPO
 Stocks that pay
 Value in the S&P500
 Cdn Top 200 2012
 US Top 500 2012
 Retirement 100: 2011
 Where to invest $100k
 Where to invest $10k
 Summer Simple Way
 A crystal ball for stocks?
 Cheap & safe
 Risky business
 Cdn Top 200 2011
 US Top 500 2011
 Retirement 100
 Dividend investing
 Value investing
 Momentum investing
 Low P/E P/B
 Dividends
 Dividend growers
 Cdn Top 200 2010
 US Top 500 2010
 Graham's prescription
 Income 100: 2009
 The case for optimism
 Cdn Top 200 2009
 U.S. Top 500 2009
 Wicked investments
 Simply spectacular
 Income 2008
 Small stocks, big profits
 Cdn Top 200 2008
 US Top 500 2008
 Value that sizzles
 So simple it works
 Income 100
 No assembly required
 Investing by the book
 Cdn Top 200 2007
 US Top 500 2007
 Invest like the masters
 A simple way to get rich
 Top Trusts 2006
 Stocks for cannibals
 Car bites dogs
 Cdn Top 200 2006
 US Top 1000 2006
 So easy, so profitable
 Top Trusts 2005
 Dogs of the Dow
 Top 200 2005
 Money for nothing
 Yield of dreams
 Return of the master

MoneySaver Articles
 2 Graham Stocks for 2017
 3 Stingy Stocks for 2016
 5 Graham Stocks for 2016
 3 Stingy Stocks for 2015
 3 Graham Stocks for 2015
 3 Stingy Stocks for 2014
 4 Graham Stocks for 2014
 8 Stingy Stocks for 2013
 6 Graham Stocks for 2013
 9 Stingy Stocks for 2012
 8 Graham Stocks for 2012
 Simple Way 2011
 5 Stingy Stocks for 2011
 7 Graham Stocks for 2011
 Simple Way 2010
 5 Stingy Stocks for 2010
 8 Graham Stocks for 2010
 Simple Way 2009
 Timing Temptation
 19 Stingy Stocks for 2009
 4 Graham Stocks for 2009
 Simple Way 2008
 Active at Passive Prices
 Unbundling ETFs 2008
 5 Stingy Stocks for 2008
 5 Graham Stocks for 2008
 Is your index too active?
 Graham's Simple Way
 Canadian Graham Stocks
 5 Stingy Stocks for 2007
 8 Graham Stocks for 2007
 Top SPPs
 The Simple Way
 A hole in your IPO?
 Monkey Business
 8 Stingy Stocks for 2006
 Graham Stock Gainers
 Blue-Chip Blues
 Are Dividends Safe?
 SPPs for 2005
 Graham's Simplest Way
 Selling Graham Stocks
 RRSP Money Market Funds
 Stingy Stocks for 2005
 High Performance Graham
 Intelligent Indexing
 Unbundling Canadian ETFs
 A history of yield
 A Dynamic Duo
 Canadian Graham Stock
 Dividends at Risk
 Thrifty Value Stocks
 Stocks in Short Supply
 The New Dividend
 Hunting Goodwill
 SPPs for 2003
 RRSP: don't panic
 Desirable Dividends
 Stingy Selections 2003
 10 Graham Picks
 Growth Eh?
 Timing Disaster
 Dangerous Diversification
 The Coffee Can Portfolio
 Down with the dogs
 Stingy Selections
 Frugal Funds
 Graham Revisited
 Just Spend It
 Ticker Temptation
 Stock Mortality
 Focus on Fees
 SPPs for the Long Term
 Seeking Solid Stocks
 Relative Strength
 The VR Approach
 The Irrational Investor
 Value Investing

Globe & Mail Articles
 Indexing advice
 Media-shy stocks
 Curse of size
 Market uncertainty
 Be even lazier
 Scary beats safe
 Small, illiquid, value
 Use the numbers
 What value is good value?
 Sculpt for value
 Value vs CAPE
 Graham Rules
 CAPE vs PeakE
 Top value ratio
 Low Beta
 Value and dividends
 Walter Schloss
 Try unloved AIG
 Why I'm a value investor
 New world of ETFs
 Low P/Es possible
 10 yielders
 Be happier
 Long-Short
 Dividend Downside
 Shiller's P/E
 Copycat investing
 Cashing in on class
 Index roulette
 Theory collides
 Diving too deep
 3 retirement villains
 Scourge of inflation
 Economic omens
 Analyst Expectations
 Value stock scarcity
 It's all in the index
 How to pick good funds
 Low Beta Wins
 Hunt for dividend stocks
 Think garage sale

Advisor's Edge Articles
 Passive Rebundling
 Doing the math

Norm Speaks
Flip Books

Tools:
 Asset Mixer
 Periodic Table
 ETF Fee Calculator



 
About Us | Legal | Contact Us
Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...