A diversified portfolio of stocks keeps you from losing everything when a particular company has troubles. If you invest in mutual funds, however, putting more funds in your portfolio doesn't necessarily reduce your overall market risk -- and it can actually increase your exposure to badly performing stocks.

So many funds, so few stocks
With thousands of funds competing for your investment dollars, funds can't avoid owning many of the same stocks. In fact, for any given stock, the number of funds that own shares of it can be huge, typically numbering in the hundreds -- and sometimes thousands.

As you'd guess, just because a stock is popular among mutual fund managers, that doesn't mean it will perform well. Take a look at some widely held stocks that have struggled in the past year:


1-Year Return

No. of Funds Owning Stock

Countrywide Financial (NYSE:CFC)



Lehman Brothers (NYSE:LEH)



Fannie Mae (NYSE:FNM)



Merck (NYSE:MRK)



Tesoro (NYSE:TSO)



Sources: Yahoo! Finance, mffais.com.

Obviously, you'd love it if you managed to pick a fund that didn't invest in any of these underperformers. If you can't have that, however, you can at least structure your portfolio so that you don't end up owning losers several times over in different funds.

An uphill battle
Finding funds with different stocks can be harder than you might think. If you look for top-performing funds, you'll usually find that most of them invest in whatever sector happens to be doing best lately. For instance, recently, energy and commodities funds have shined. But it doesn't matter how many different energy funds you buy -- your fortunes will still rely solely on whether or not the sector continues to do well.

Even among broader funds, there can be a lot of overlapping holdings. If you look at two of Fidelity's most popular funds, Magellan and Contrafund, you’ll notice several stocks they both invest in, including Research In Motion (NASDAQ:RIMM), Google, Gilead Sciences (NASDAQ:GILD), EOG Resources, and America Movil. And that's just among the funds' top 25 holdings.

Know your funds
To protect your money, it's not enough to spread your money across many different funds. You also have to be smart about the funds you pick and make sure they don't all focus on the same parts of the stock market.

That's where knowing the investment objectives your funds are following comes in handy. If you own two specialized funds, one of which invests in large U.S. growth companies while the other buys small international stocks, odds are good that you won't own the same stock twice. On the other hand, buying several funds that all focus on large-cap value plays will probably give you multiple exposure to quite a few companies.

An undiversified portfolio isn't always bad
Of course, there are times when you might be willing to take on the added risk of owning stocks in several different funds. One case is when you have a set of core mutual funds for the bulk of your assets but also make small sector-related bets based on current market conditions. In that case, you're actively looking for that double exposure and making a deliberate choice to go beyond whatever investments your core funds have made in a given sector.

The key, though, is to be aware that buying more funds won't necessarily give you more protection. If you think adding another fund will automatically protect you from a downturn in particular stocks, you may well be in for a nasty surprise.

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