Don't spread your portfolio too thin

By Morningstar

Anyone who has spent much time reading about personal finance knows the value of diversification in a portfolio. If you put all your money into just one or two investments -- stocks, bonds or anything else -- you run the risk that something will go wrong and wipe out a big chunk of your nest egg. (Enron, anyone?)

By spreading out your investments, you smooth out returns and lessen the effect that any one holding can have. Modern portfolio theory has shown that a diversified portfolio has a better expected return, for a given level of volatility, than a portfolio that is concentrated in just a few issues.

Mutual funds offer automatic diversification, which is one reason they've become so popular. It's still a good idea to diversify among different funds, though, in order to prevent one fund or asset class from dominating a portfolio. A lot of fund investors learned this lesson the hard way during the technology bubble of the late 1990s, when their tech-heavy portfolios rose to dizzying heights and then fell to earth hard.

But is it possible to be too diversified? Absolutely. After a certain point, adding more funds to your portfolio just creates additional bookkeeping and tax headaches while doing little or nothing to increase returns or lower risk. When dozens of mutual funds are thrown together, the result tends to be indistinguishable from that of an inexpensive index fund because any differences among the funds become diversified away. In terms of risk, one Morningstar study found that a portfolio of four domestic-equity funds already provides most of the diversification benefits of larger portfolios and that there's virtually no difference between a portfolio of nine funds and one of 30 funds in terms of volatility.

However, there's no exact number of funds beyond which you're automatically over-diversified. A lot depends on your goals and the types of funds you own. Here are some tips for determining whether your portfolio is over-diversified, as well as some ideas for correcting such problems when they do arise.

The perils of over-diversification

As a case study of what can happen when diversification runs amok, consider Chief Justice John Roberts of the U.S. Supreme Court. As a federal judge, Roberts is required to file financial-disclosure reports each year, and when he was nominated to the high court last year, those reports attracted a fair amount of scrutiny. Roberts' most recent disclosure report is from 2003. At the time he filled out the disclosure form, Roberts owned 46 common stocks and 31 mutual funds, along with several money-market funds, bank accounts and miscellaneous other investments. That's way more stocks and funds than any one investor really needs, especially given the amount of overlap in Roberts' portfolio.

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Roberts' largest fund holdings were in Fidelity Magellan (FMAGX) and Merrill Lynch S&P 500 Index (MDSRX). Those were reasonable choices for the core of a portfolio, though Roberts was paying much more than he needed to (0.6%) for a Standard & Poor's 500 Index ($INX) fund. However, most of Roberts' stock holdings were blue chips that he already owned indirectly through the above mutual funds, such as Time Warner (TWX, news, msgs) and Microsoft (MSFT, news, msgs), the publisher of MSN Money. He did own a big chunk of XM Satellite Radio (XMSR, news, msgs), though, one of the few really risky stocks in the portfolio.

The rest of Roberts' portfolio contained an eclectic mix of funds. There were some decent diversifiers for his core portfolio, such as Vanguard Small Cap Index (NAESX) and several sector funds. But there were also some head-scratchers, such as a small stake -- less than $15,000 -- in Fidelity Freedom 2010 (FFFCX), a target retirement fund designed to be an all-in-one offering. Even more oddly, Roberts owned no fewer than eight foreign and world-stock mutual funds: Fidelity Overseas (FOSFX), Mutual Discovery (MDISX), GAMCO Global Growth (GGGCX), Janus Worldwide (JAWWX), Merrill Lynch International Value (MDIVX), T. Rowe Price European Stock (PRESX) and ING Emerging Countries (NECAX), plus the closed-end New Ireland Fund (IRL).

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