Many investors turn to mutual funds in order to get instant diversification without having to invest tens of thousands of dollars at once. Yet while the right mix of mutual funds can help you create a diversified portfolio that gives you broad exposure to a wide range of financial markets, you have to stay on the lookout to avoid unnecessary overlap in the stocks your funds own.

Given how easy it is to invest in funds, you may think you don't really need to look too closely at the individual stocks your funds choose. But if you don't, you may never know that the funds you own actually hold many of the same stocks.

So many stocks, but …
You might think that it'd be easy for different types of mutual funds to avoid owning the same sorts of stocks. After all, with so many different ways of classifying stocks into various categories, a fund that limits itself to buying stocks within a particular classification seemingly shouldn't own the same companies as a fund in a different classification.

Yet it can be extremely difficult to buy funds that don't have overlapping holdings. Consider just how many funds own shares of some of these well-known stocks:

Stock

Number of Funds Owning Shares

Johnson & Johnson (NYSE:JNJ)

2,299

General Electric (NYSE:GE)

2,273

JPMorgan Chase (NYSE:JPM)

2,152

ExxonMobil (NYSE:XOM)

2,122

Pfizer (NYSE:PFE)

2,025

Source: mffais.com.

Moreover, this overlap doesn't just come from the fact that there are so many mutual funds of the same type. For instance, looking at holders of shares of Microsoft (NASDAQ:MSFT), you'll find:

  • S&P 500 and other broad market index funds
  • Large-cap growth funds
  • Large-cap value funds
  • Global funds
  • Specialty funds such as tech sector funds
  • Small-cap and mid-cap funds

Similarly, you'll find shares of AT&T (NYSE:T) held in all sorts of funds, from those that focus on dividend income to growth funds, and some small-cap funds.

Clearly, either some fund managers have widely disparate opinions about what makes a stock fall into a particular category, or they stray from their particular objectives in order to buy shares of other stocks.

How to get true diversification
So, how do you make sure you don't own the same stocks in too many of your funds? You have a couple of options.

One simple way of dealing with the question is to realize that unless several of your funds own large concentrations of a particular stock, some duplication won't hurt. For instance, if one fund you own has 0.2% of its assets in a company and another has 0.1%, it still won't add up to a concentrated position. So, simply monitor the top holdings lists of your funds and make sure you don't see too many of the same names repeatedly.

But if you really want to make sure you're getting the most diversification you can, consider these strategies:

  • Go with index funds. Unlike actively managed funds that can stray from their investment objectives, index funds tend to stick with a mechanical approach. So if you choose funds based on indexes that don't have overlapping components, you shouldn't see any duplicated stocks.
  • Invest by sector. Similarly, most sector funds have a tough time justifying investments outside their target industry. So by putting together a portfolio of sector funds, you probably won't see much overlap.
  • Look at different fund families. Often, funds run by the same fund company share their best ideas, and so a given stock may end up in several funds in that fund family. By going to funds run by other companies, you maximize the breadth of overall investment expertise and are more likely to get different stock ideas based on another professional's perspective.

If you're concerned about the risk in your portfolio, diversification is important. So, don't automatically assume that if you own a bunch of different mutual funds, you automatically have as much diversification as you could possibly get. At the same time, though, realize that a little diversification goes a long way -- and you don't need to eliminate all the overlaps in your fund portfolio in order to manage your risk well.

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Fool contributor Dan Caplinger is as diversified as he cares to get. He owns shares of General Electric. Johnson & Johnson is a current Motley Fool Income Investor recommendation, while JPMorgan Chase and Pfizer are former ones. Microsoft and Pfizer are Motley Fool Inside Value recommendations. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy makes you smarter.