Careful when Diversifying Mutual Funds

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I previously mentioned that I don’t like mutual funds. However, that does not mean everyone else should. If I knew about and had the opportunity to invest in Peter Lynches Magellan Fund, or Pabrai’s fund, I would very well consider investing in those funds.

Quality Funds

However, high quality funds are hard to come by. There are literally thousands of funds out there and we are supposed to wade through it somehow. Here is a tip.

Look Before Buying

Along with all the usual things to look out for when investing in mutual funds, such as low, low, LOW expense ratios, turnovers, managing style etc, one thing that people should consider when buying or diversifying mutual funds are its holdings. When people diversify by buying several funds, they tend to forget that funds hold thousands of positions. The normal fund snapshots only display the top 5 or 10 holdings, and so we tend to ignore the other 995 or so. Also, similar types of funds also tend to have the same holdings.

Overlapping Funds

For example there are two growth funds, A and B. Their top 10 holdings consist of the following;

Fund A: Google, Microsoft, Apple, Yahoo, Nokia …

Fund B: Google, Yahoo, Cisco, Microsoft, Garmi …

The above is an extreme example but I’m sure you get the point. When an investor purchases both A and B funds, they are essentially paying for the same company twice. Also, fund A may decide to buy more Google while B sells Google. Again, the investor ends up paying for transactions that are useless to himself.

This Post Is Too Basic?

I bring this up because as I was viewing the different types of funds available in my 401k, I wasn’t very impressed with the selection. Most of the readers here probably know this already, but at least you could pass it on to those who need the tip. After all, what’s the point of getting rich by yourself? 😉

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