Depending on which money manager you talk to, it takes from 20 to 30 stocks to create a portfolio that's truly diversified. But if you hold that many stocks, you should be keeping tabs on each and every one by following earnings and revenue reports as well as news that could send investors scurrying for the exits.
That's why most beginning investors are better off investing in mutual funds and leaving stock picking to the pros. Fund managers make it their full-time job to track stocks and build in diversification -- spreading the risk so all the holdings don't go up and down at the same time. But just because you own a few funds doesn't mean you're automatically diversified.
Mix it up with style
To understand diversification, you need to know that funds have a specific focus, what's referred to as investing "style" -- large-company growth, for instance, or small-company value. Style is a loose description of what types of companies the fund manager looks for. Large-cap growth funds should own stocks of big companies that have the potential to grow year after year. Small-cap value funds, on the other hand, look for small companies that are selling for less than what market analysts think they're worth.
Best way to get a diversified portfolio, says Alan Friedman, portfolio manager for the Armada fund family, is to make sure you have your hand in a little bit of each style. Friedman recommends owning at least five funds, each representing the major styles: large-cap growth, large-cap value, small-cap growth, small-cap value -- plus an international fund. Investors nearing retirement or who expect to need income might want to add a balanced fund, which has more income-producing securities.
Fund styles fall in and out of favor almost as abruptly as women's fashion, especially when the markets are in transition and you don't know which way they're going to go. Peter Di Teresa, a Morningstar senior fund analyst, points to the downfall of large-cap and growth funds at the start of the bear market in 2000. Small-cap funds -- especially small-cap value funds -- were the stars after that.
But you had to have been a fortuneteller to see that coming, he says. If you diversify, you can benefit no matter which direction the market is going without playing the losing game of trying to time the market. In a volatile market, for example, which style is in vogue is likely to shift without warning.
Owning funds with different styles also makes sense because it's not always clear under what conditions one style will shine. A lot of it has to do with economic conditions, says Robert Sullivan, portfolio manager for Satuit Capital Management. Small-cap funds tend to outperform large-caps coming out of a recession, he says, because most of their revenues come from the domestic economy. Big companies usually get a good deal of their revenues from overseas, where the recovery tends to take longer than in the U.S.
Fund managers like to emulate the investing strategies of successful peers, so it's easy to unwittingly own too much of a sector or stock even though you've invested in more than one fund.
The easiest way to avoid overlap, says Friedman, is to pick funds that stay true to their style. Kiplinger lists each fund's style in Fund Finder. Another quick way to gauge fund style is to log on to Morningstar.com and type in the fund symbol, then scroll down to the style box. If you typed in JANSX, the symbol for Janus Fund, for example, you'd see that it invests in large companies with growth potential and has most all of its assets in stocks.
Another way to avoid duplication is to compare your funds' top-ten stock holdings and sector breakdowns. You can get that info on Kiplinger.com's fund-quote page by typing in the fund symbol and clicking on "holdings."
If you're really diversified, says Di Teresa, you'll get stability and the probability that at least one of your funds will be in positive territory no matter what the market's doing.