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 can 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 eight-to-15 (or so) stocks that Fools with the time and willingness to invest in individual stocks should shoot for.
To better appreciate the problem of overdiversification, take a look at Fidelity's mammoth Magellan Fund (FUND:FMAGX). As of Sept. 30, 2003, its biggest holding was Citigroup (NYSE:C), representing 4.5% of the fund's value. If an investor had plunked $3,000 into Magellan then, she'd own only $135 worth of Citigroup, between two and three shares' worth. And that's the biggest holding. Of her $3,000, $273 would be divided among 11 pharmaceuticals companies -- such as Pfizer (NYSE:PFE) and Merck (NYSE:MRK) -- for an average of $24.82 each. Some $66 would be divided between seven "communications equipment" companies -- such as Cisco Systems (NASDAQ:CSCO), Motorola (NYSE:MOT) and Nokia (NYSE:NOK) -- amounting to an average of $9.43 each.
Being spread so thin is problematic, because 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 Linear Technology (NASDAQ:LLTC) 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 $6 to $18. If an individual investor had invested $3,000 in 10 companies in equal proportions, and one had been Linear Technologies, the Linear Tech. 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 owning 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 its value, $3 billion, on Starbucks (NASDAQ:SBUX). Oops. Starbucks' entire market value (at the time of this writing) is closing in on $15 billion. Your $3 billion would buy a full 20% of the entire company, which you can't do. Most companies are far smaller than $15 billion in size. KrispyKreme Doughnuts (NYSE:KKD), for example, has a market cap of around $2 billion, at the time of this writing.
If you're limited -- as many managers are -- to not buying more than 10% of any one company, then you could spend only $200 million on Krispy Kreme. It's hard to avoid spreading yourself too thin when $200 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 tend to beat the averages over time. We just launched a new newsletter to highlight promising mutual funds for you -- check out our Motley Fool Champion Funds.
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.
