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
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
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
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.