Imagine you're suddenly given $30 billion. You'd probably be pleased. But if the money were given to you as a stock mutual fund that you had to manage, you'd run into some problems. Mutual funds have strict rules that make effective investing difficult. The bigger many funds get, the more their performance can suffer.
For starters, you'd likely have to keep 5-10% of the fund's value in cash to cover withdrawals when people sell shares. You also probably wouldn't be able to invest more than 5% of the fund's value in any one stock, limiting you to no fewer than 20 stocks. Typically, mutual funds invest in 50-200 different companies, a far cry from the 8-15 (or so) stocks that we suggest Fools shoot for.
To better appreciate the problem of overdiversification, take a look at Fidelity's mammoth Magellan Fund (FUND:FMAGX). As of March 31, 2005, its biggest holding was General Electric, representing 4.1% of the fund's value. If an investor had plunked $3,000 into Magellan then, she'd own only $123 worth of General Electric. And that's the biggest holding. Of her $3,000, $186 would be divided among 11 pharmaceuticals companies such as Johnson & Johnson (NYSE:JNJ) and Merck (NYSE:MRK) -- for an average of $31 each. Another $99 would be divided between 11 "communications equipment" companies such as Cisco Systems (NASDAQ:CSCO), Motorola (NYSE:MOT), and Qualcomm (NASDAQ:QCOM) -- an average of $9 each.
Being spread so thin is problematic. When you're invested in hundreds of companies, if some of them do very well, their impact is diluted by the many less-stellar performances. If Jabil Circuit (NYSE:JBL) triples in value one year, for example, even though you may have $3,000 invested in Magellan, your stake in it might simply go from $4 to $12. If an individual investor had invested $3,000 in 10 companies in equal proportions, and one had been Jabil Circuit, the Jabil stake of $300 would have turned into $900, increasing the portfolio value by 20%. The more companies you own, the more dilution becomes a problem.
Even if your fund limits itself to the minimum number of stocks, though, other problems arise. Let's return to your imaginary $30 billion fund. Imagine that you want to (and can) spend 10% of your fund's value, $3 billion, on Starbucks. Oops. Starbucks' entire market value (at the time of this writing) is close to $21 billion. Your $3 billion would buy a full 14% of the company, which you can't do. Most companies are much smaller than $21 billion. Krispy Kreme Donuts, for example, has a market cap of around $500 million at the time of this writing, down from $2 billion not so long ago.
If you're limited -- as many managers are -- to not buying more than 10% of any one company, then you could spend only $50 million on Krispy Kreme. It's hard to avoid spreading yourself too thin when $50 million is merely a drop in your mutual fund's bucket.
Pity the mutual fund managers. Working with much less freedom and a lot more money than we have, the odds are stacked against them. It's no surprise that most of them underperform the market average.
Of course, a few funds do beat the averages over time. We offer a nifty newsletter that regularly highlights promising mutual funds for you -- Motley Fool Champion Funds. Together, the picks of our analyst, Shannon Zimmerman, have more than doubled the market's return (last I checked), with a bunch racking up double-digit gains in the last year.
Learn much more in these articles:
- The Case for Mutual Funds
- Slam-Dunk Mutual Funds
- You're Paying How Much?
- Champion Funds Still Beating the Market
- Three Reasons to Sell
- Is it Time to Sell?
You can take much of the headache out of investing and meet the market average by investing in index funds, which everyone from Fool co-founders David and Tom Gardner to John Bogle to Warren Buffett recommend. Learn much more about mutual funds in our Mutual Fund area and our Index Fund area.
