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Wall Street, California: Time for a Tuneup

How Many Funds Do You Need?


Betcha wish we'd answer that question. It's a puzzler.

Academic research says you can build a sufficiently diversified portfolio with just 20 stocks, but it's not unusual for investors to own 1,000 different securities through 10 mutual funds. Yet a fund with 130 holdings can lose 25% in a quarter. That hardly seems like the result of good diversification.

So do you need two stock funds? Eight? Fourteen?

Take your pick. Fact is, the answer to the question isn't a number, it's a process. Think of it as an essay question, not a multiple-choice test.

But to begin, figure out what scares you most:

a) Losing 10% of your assets in a month;

b) Killing your shot at top returns;

c) Needing $100,000 at a specific time for a specific purpose (retirement, kid's college, etc.) and falling $25,000 short.

Your answer to this question will help determine how many funds you should own. Generally, the more funds in a portfolio, the lower the short-term volatility--ups and downs--and the narrower the range of long-term results.

On average, short-term volatility declines dramatically as you add the first four equity funds, falls further with the next four or five funds, and then begins to level off. For many investors, however, short-term volatility matters less than how many dollars will be there when all is said and done. In other words, the destination is more important than the trip.

Increasing the number of funds narrows the range of probable destinations (see accompanying graphic).

Of course, a narrow range can be friend or foe, depending on how you answered the quiz. If you're aiming to beat the market, you'd be more interested in the top line of the graph. The more funds, the worse the odds of making the big bucks. If, however, your biggest fear is not having enough money to meet your goals, the bottom line will be more relevant. More funds equals more certainty.


Excerpted from the June 1997 issue of Morningstar Investor.


Closing the Gap

Up to a point, An investor aiming for $100,000 increases the likelihood of hitting that target by holding more funds.


Three funds in portfolio Likely performance range: $85,00-$116,000


17 funds in portfolio Likely performance range: $92,000-$108,000

Note: $125,000 ending portfolio value based on $51,382 initial investment five years ago.



We gathered our data by randomly constructing 200 domestic-equity-fund portfolios for each portfolio size (200 one-fund portfolios, 200 two-fund portfolios, etc.).

We also calculated the likely ending portfolio value for each portfolio size. (See graph.) We began by assuming a target value of $100,000. The average domestic-equity fund would have needed an initial investment of $51,382 five years ago to reach that target. Based on that initial investment, we show the likely range of performance for each portfolio size. There's a 95% chance that the ending value would fall between the upper and lower values shown on the graph.



About Morningstar

Morningstar Inc. is a privately owned company founded in 1984 to provide investors with independent information to help them make investment decisions. Its star rating system is used by financial planners, cited in advertisements and used as a guide by investors and the media alike. As it has grown, the Chicago-based company's staff of analysts, writers and programmers has introduced new print and software products for both the individual and the professional investor. These include the investors' guides Morningstar Mutual Funds and Morningstar Investor, and CD-ROMs "Morningstar Principia for Mutual Funds" and "Morningstar StockTools." To learn more about Morningstar and its products, call (800) 735-0700 or visit its Web site at

By the way, the name "Morningstar" is a reference to the last line of Thoreau's "Walden": "The sun is but a morning star."


Morningstar Categories

Morningstar's categories are intended to distinguish funds by what they own as well as by their investment objectives and styles.

While traditional fund definitions have often simply identified a fund's investment goals based on the wording in the fund prospectus, Morningstar looks at the actual stocks they have held to decide which category they should fall under.

If the fund is new and there is no data on its holdings, the choice is based on the best information available. Morningstar will change a category assignment based on new information.

Domestic Equity Funds

General domestic equity funds are placed in a category based on the style and size of the stocks they own. The style and size parameters are based on the divisions used in the investment style box:

Domestic Specialty Funds

LG: Large Growth

MG: Mid-Cap Growth

SG: Small Growth

LB: Large Blend

MB: Mid-Cap Blend

SB: Small Blend

LV: Large Value

MV: Mid-Cap Value

SV: Small Value


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