George is a 70-something investor from West Palm Beach, Fla., who has been made a bit crazy by the stock market recently.
Still, in reading my column last week -- which discussed how the market is giving investors a chance to upgrade their portfolios -- he wanted to know whether an investor could improve a portfolio simply by adding "more and better funds."
"Do I have to sell what I have, or can I just add more to the mix?" George wrote in an e-mail. "In this kind of market, I would think more funds give me more protection from the market. ... If that's not right, then what's the correct number of funds for an investor to own?"
It is an outstanding question at a time when investors are looking to strike the right balance between safety and aggression, wanting to capture the best returns they can get without taking on too much risk. But it also highlights some common misconceptions about funds.
With actively managed mutual funds, more is not necessarily better. Studies show that owning four funds in the same asset category is virtually certain to create a "closet index fund," which means that the combined performance of the funds winds up doing no better than the index for that asset class; worse yet, that index-or-worse overall performance comes at a much higher cost than simply owning a mutual fund or exchange-traded fund tracking the index.
"It's a good time to check up and see if your fund is performing worse than you would have expected in a tumultuous environment," said Christine Benz, director of personal finance at Morningstar Inc. "If performance is worse than you expected, then maybe the fund is a bad match for your risk tolerance."
But citing the closet index fund issue, Benz noted that she would prefer to replace the fund, rather than simply add another one to the mix, noting that in her opinion two funds in an asset class is sufficient.
"Fewer [funds] is better," she said. "The fewer moving parts you have with your portfolio, the better off you will be."
George's basic premise that more funds might provide market protection is not entirely incorrect, however. The key issue is what each fund does, and how it plays with others.
Fund investors working on a portfolio need to consider "correlation" -- the term experts use to describe how much two funds move in sync -- overlap and allocation.
"Culling your weaker performers is an obvious move when the market is making you nervous, but if you invest everything back into the same asset class -- even if it's in a better fund -- you may still be kind of nervous," says Mark Salzinger, editor of the No-Load Fund Investor newsletter. "I don't want overlap, and I probably do want things that don't correlate."
For example, gold funds are considered an inflation hedge and while they typically move in sync with oil and energy sector funds, they tend to move in the opposite direction of the dollar. Likewise, international and emerging markets funds have not been taking the same beating that some domestic funds have over the past few months.
That brings the discussion to overlap. An investor looking to branch out and expand the assets they hold may sometimes be fooled a bit by what they own. Plenty of vanilla growth funds, for example, have some international flavoring for up to 25 percent of the portfolio. Many foreign stock funds already have exposure to emerging markets.
Investors should not just look at what their funds own based on their name or general asset classification, but should dig in to see the most recent snapshot of where the money is actually invested. In that way, if they plan to add funds, they can minimize the overlap, the potential for closet-index results, and can maximize the benefits of diversification.
Ultimately, an investor can build a terrific portfolio with no more than six funds covering domestic and foreign markets, large, and small stocks, bonds and money markets. Sector funds and other issues can be used to flesh out the holdings and tilt the assets to areas the investor prefers, without creating massive overlap with the core holdings.
Charles Jaffe is senior columnist for MarketWatch. His postal address is Box 70, Cohasset, MA 02025-0070.