Should you hold multiple mutual funds?

Should you hold multiple equity funds? Yes!

One of the more frequently asked questions from family and friends is whether there is any advantage to holding multiple mutual funds or whether a single fund yields the same diversification benefits.

Fortunately Louton and Saroglu shine some light on this question in their working paper "Individual Investors' Asset Allocation and Number of Mutual Fund Holdings."

Using simulations, they investigate various asset allocation schemes along with the number of funds held in equities, bonds, and cash. They find that holding multiple funds (especially in equity) does reduce risk (as measured by standard deviation of terminal wealth) significantly

The authors also report that the benefits of multiple funds are, as expected, greatest when there are multiple equity funds. In fact, a suggested strategy that comes out of this work is to diversify more heavily within equity funds (where there is great dispersion and lower correlations) and less (if at all) within cash and bond funds.

Some look-ins:

• "The results....for each scenario for investment horizons of 5 and 7 years. Regardless of asset allocation weights and investment horizons, holding 18 funds in the portfolio instead of the minimum possible 3 funds as dictated by the choice of 3 asset classes enables the investor to reduce the standard deviation of terminal wealth by about 55%."
• "...the average terminal wealth level at the end of each investment horizon
  remains the same as the number of funds in the portfolio increases"
• "holding multiple funds in the dominant asset class together with one fund in each other asset class results in similar diversification benefits compared to holding multiple fund portfolios with equal number of funds in each asset class. These findings confirm the intuition that management style differences are less significant for bond and money market mutual funds...."
  

Of course this does ignore costs of accounting for various funds etc, but a reduction of risk of this magnitude seems to be well worth a few extra mailings.

BTW The best recap of the paper is found in table 3.

This will be presented at the FMAs in Salt Lake City (Thursday October 12).