The Dangers of Diversification

Chocolate. Power. Beer. In small doses, these are good things. However, history teaches us that too much of a good thing can be dangerous -- for your waistline, ego, and liver, respectively.

What's true for chocolate also is true for diversification. Small amounts of each can be beneficial, but go too far and you'll only wind up feeling bloated.

Funds offer cheap diversification ...
Diversification is one of the key benefits of mutual fund investing. By investing in a broad range of securities, mutual funds reduce the effect of a possible decline in the value of any single stock. According to the Mutual Fund Education Alliance, if an individual investor tried to create his own diversified portfolio of 50 stocks, he would need at least $100,000 in starting capital, and he would have to pay thousands of dollars in commissions.

Although those numbers seem a tad inflated (note to the MFEA: Try a discount broker), they still illustrate a valid point. Mutual funds offer individual investors instant diversification at a bargain price.

But is that a good thing?
There's a flip side to the diversification coin that the MFEA neglected to mention. By investing in a broad range of securities, mutual funds also reduce the upside potential of winners.

All else equal, a superstar stock will have a more significant effect on a portfolio of 25 securities than it would on the same size (in dollar terms) portfolio containing 50 stocks.

Know when to say when
Experts disagree on the number of names that should comprise a well-diversified portfolio, but the general consensus is anywhere from 10 to 40 stocks should get the job done. Yet most mutual funds have far more than 40 stock holdings -- and some have portfolios containing 100 names or more! Remember, the goal should be to beat the market, not be the market.

What not to do
American Funds' Investment Company of America (AIVSX) is one of the most popular mutual funds in the world, with approximately $95 billion under management and more than 3 million shareholders. Its portfolio contains 161 stocks, many of which should feel quite familiar:

With the glaring omission of ExxonMobil, the top holdings in the Investment Company of America fund look an awful lot like the largest companies in the S&P 500. With $95 billion in cash to spend, it's no wonder why this fund owns so many companies -- and why it's restricted to the largest of the large-caps.

When you consider that this fund charges investors a 5.75% initial load and a 0.23% annual 12b-1 fee (used to pay for advertising expenses), that's a recipe for subpar returns.

A better way to bigger returns
At Motley Fool Champion Funds, we trust our fund managers to deploy capital effectively, not just mirror an index. We look for experienced managers with a steady investment strategy and a proven track record through bull and bear markets alike.

We prefer a concentrated portfolio of a manager's best ideas to a bloated, 161-stock compilation any day. And we would never dream of recommending a fund that charges investors a load fee.

To see our list of the best funds the market has to offer, click here for a 30-day free trial. There is no obligation to subscribe.

Rich Greifner owns shares in Fannie Mae and Nokia. Fannie Mae and Microsoft are Inside Value recommendations. The Fool's disclosure policy thinks load fees are for chumps.