Hi, my name's Nathan, and I'm a mutual fund addict.
It all started innocently enough. They say college is the time for experimentation, so midway through my senior year I decided to try something new and exciting. All of the financial publications I read at the time were packed with mutual fund advertisements touting the outsized performance of their latest five-star, can't-miss offerings.
Allured by the prospect of making a few quick dollars -- ideally to pay off my mounting student loan debts -- I plunked down a few dollars on my very first mutual fund.
It was an exhilarating run, but when the dust finally settled a few years and a dozen or so funds later, I was left with a cluttered mess of unrelated products that resembled more of an eBay mixed lot listing than a carefully orchestrated portfolio.
It all began when.
I loved that first fund, and would routinely call its toll-free number (in the mid-1990s, performing such a simple task online was well beyond my limited technical grasp) to check out the Net Asset Value (NAV), which typically had gained a few cents from the day before. Before long, my first statement showed an intoxicatingly easy gain. But why stop at one. Wasn't the whole point to diversify? Naturally, once I was hooked, it was time for further exploration.
I knew that large-cap value funds were supposed to be more stable, and feeling a little more uninhibited now, I quickly bought one. Next, I set my sights on small-cap funds, which were billed as having more upside potential. Upside potential was good -- better get one of those also. After that, someone informed me that mid-cap funds combined the best of both worlds. The logic made sense, so I felt compelled to add one of those to the collection. I saw no problem with my behavior. After all, I could stop anytime.
Stopping was the furthest thing from my mind, though. A portfolio consisting entirely of equities was a little too volatile, even for an adventurous risk taker like me, so I tempered it with some investment-grade bonds. The abysmally low monthly payout didn't really excite me, however, so I threw in a high-yield fund to the mix. I was beginning to feel very proud of my newly constructed portfolio. Stocks, bonds, big companies, small companies -- I had all the bases covered. Or did I?
Getting in over your head
Of course, I knew I had forgotten something. There was no exposure to Europe or Latin America or emerging markets. My portfolio was completely devoid of international stocks. I couldn't be expected to restrict my investment horizons to just a relative handful of domestic stocks, not when there were so many overseas opportunities waiting out there. I knew that FranklinResources'
By now, the tech bull market was in full swing, and stocks such as Qualcomm
After that, I began to accumulate funds the way others might choose a new book from Barnes & Noble -- by the author or even the cover. Anytime I read an interview with a portfolio manager whose management philosophy and stock-picking prowess seemed like a winning combination, his fund would suddenly ping on my investment radar screen. Whenever I ran across a new fund with an interesting story to tell, I would usually stop and listen.
Judgment
Day
Eventually, the day came when I knew I had a problem. An unrelenting three-year bear market brought the giddy optimism that defined the late '90s crashing back to earth, and it took my funds along for the ride. In the end, the large portfolio I had painstakingly crafted was essentially reduced to slivers -- many slivers. My bond funds softened the blow, as they were designed to do, but ultimately I was not spared from the market's wrath. After the crash, I was able to remove the black box from my shattered portfolio and analyze what went wrong.
Overlap: As I suspected, my funds had some degree of overlap. For example, I already owned a solid large-cap value fund, as well as a corporate bond fund, when I purchased the American Funds Balanced
Monitoring: A mutual fund portfolio, just like one composed of stocks, needs to be reviewed periodically, and owning too many of either can be problematic. My money was spread far too thin for any one fund to make an appreciable difference, and keeping tabs on all those picks was time consuming. Eventually, I lost track of a few of them. Tax reporting was no picnic either, as anyone who has filled out a 1040 Schedule D with a shoebox of financial statements can attest.
Mutual fund owners may not have to worry about margin expansion or free cash flows, but they have their own measures to consider. Obviously, a fund's track record against a benchmark or peer group is important, but that is only the beginning. Factors such as turnover, style drift, beta, tax efficiency, managerial changes, expense ratios, and portfolio composition must also be weighed. It's not quite as simple as flipping through Money magazine to find the 50 hottest funds from the year before and then falling asleep at the wheel.
Asset allocation: The proper way to construct a portfolio is to first determine -- based on risk profile and other factors -- a suitable asset allocation model (i.e., what percentage goes to large-cap value or short-term bonds). Only then should the investor search for the best funds to represent each category and split his assets accordingly. Plenty of homework underpinned my fund selections, but not enough went into prioritizing them. Those who randomly buy funds here and there that look promising without assessing their role in the context of a broader strategy are not truly assembling a portfolio but merely adding new pieces to a collection.
Overdiversifying: I used to visit Harrah's
In an attempt to have meaningful exposure to every nook and cranny of the market that might suddenly soar, I accumulated far more funds than was necessary. This type of mentality inevitably leads to mediocre performance. It is not feasible to include every fund that looks attractive from a fundamental standpoint, just as it is senseless to throw money at every sector that suddenly turns hot. With more than 10,000 available, many are going to seem worthy of admission. Morningstar tracks and compiles data for more than 50 different mutual fund categories -- seven pertaining to municipal bond funds alone. Clearly, investors must draw the line somewhere.
Rehabilitation
In the years since I managed to curb my addictive behavior, my investment returns have improved markedly. Before, there were just too many working parts. Now, if a new mutual fund catches my eye -- and many do, because Motley Fool Champion Fundsintroduces me to great ones every month -- I will only consider it to replace a laggard or for rebalancing purposes. And now that Champion Funds is in the process of rolling out model portfolios, I have a high-quality yardstick against which I can judge my own lineup. Handy, no?
Remember, though, that when deciding how many funds to own, there is no magic number, no right or wrong answer, and no rule of thumb. For a first timer with a modest bankroll, a single low-cost index fund -- such as the Vanguard 500 Index
Motley Fool Champion Funds is an invaluable guidebook for the mutual fund traveler, singling out the best places to visit and those to avoid. Before you take the next trip, sign up for a free trial .
Fool contributor Nathan Slaughter owns none of the companies mentioned. The Fool has a disclosure policy.
