Sunday, May 18, 2008

Long-term investors beware...

In a recent MarketWatch article, Chuck Jaffe who writes a column titled "Stupidest Investment of the Week" (link), talks about a specific Vanguard mutual fund that essentially invests all the other managed Vanguard mutual funds. Jaffe suggests, and I agree, that this type of diversification is over-diversification, or a type of risk aversion akin to keeping your money under 8 mattresses instead of one.

While most readers know I enjoy risk, my retirement funds are long-term focused. I've often debated the risks of holding one good stock (leading to high risk) or just holding something safe (Treasury bills). Classic finance would tell you that the ideal location is somewhere in between; a good mix of high risk and low risk investments.

Jaffe writes, "Studies have shown that holding more than four funds that cover the same ground results in a 'closet index fund,' where an investor pays the price for active management but winds up with the performance of an index fund."

People sometimes take mutual funds and diversification too far, believing that spreading their money around to various mutual funds meets the criteria of diversification. Instead, look at each mutual fund's holdings and find out if you are duplicating sectors. If you are, rather than holding two mutual funds and paying double the management fees, just put twice as much into one mutual fund and get out of the other.

2 comments: said...

Investing in a "fund of funds" that invests in actively managed funds does have the potential for ending up with index-like performance but paying active management level fees (although the proponents of these met-funds would argue that if they have skill in picking which funds to invest in you are still buying outperformance, but with lower risk).

However, a fund of index funds (such as the Vanguard HighGrowth fund I invest my retirement funds in) offers a combination of diversification, asset allocation and automatic rebalancing for minimal cost - nothing like the costs of most actively managed funds.

Finance Guy said...

I was going to bring this up tomorrow, but if you just want an index fund, but one of the Exchange Traded Funds (ETFs) that follow an index (DIA,SPY,QQQQ). It provides much better liquidity and much lower management fees.