For holding periods of many years, diversification improves dramatically, when you hold multiple actively-managed mutual funds in an investment portfolio.
In “How Many Mutual Funds Constitute a Diversified Mutual Fund Portfolio?,” Professor Edward O’Neal of the University of New Hampshire at Durham tackled the important question of how much an investor could improve on diversification by holding multiple actively-managed mutual funds within an investment portfolio.1
For the companion article describing this study, see: How many mutual funds are needed for a well-diversified portfolio? – evidence
Because individual investors typically stay invested in particular actively managed mutual funds for many years, a terminal valuation approach is useful in understanding the variability of outcomes for a mutual fund buy-and-hold strategy.
Professor O’Neal found that, if one looks only at average year-to-year portfolio risk or volatility, then adding more mutual funds to a portfolio seems to improve diversification only very slightly. However, if you look at terminal investment portfolio values after multi-year investment holding periods, then very substantial reductions in investment risk can be achieved by owning multiple actively-managed mutual funds.
Professor O’Neal pointed out that individual investors plan for college or retirement expenses with long investment horizons. They are most concerned with the likelihood of achieving their end-of-period investment goal. Therefore, the variability of cumulative returns at the target time or the “terminal wealth” is of greatest concern to these investors.
Professor O’Neal compared actively-managed mutual funds with similar styles, i.e. “growth-and-income” style mutual funds and “growth” style mutual funds to determine the value of increased diversification within a particular investment strategy, rather than across several strategies.
Over long investment holding periods, uneven performance from one mutual fund and another can be very dramatic and can result in a wide range of total investment returns.
Professor O’Neal noted that “the average growth fund return over the 19-year period was 1,502 percent, although the distribution is skewed to the right (the range was 543 percent to 6,794 percent).”2 This means that the best performing growth mutual fund returned over 12 times that of the worst performing growth fund that had survived for the full 19-year period.
The worst surviving growth mutual fund was undoubtedly not the worst growth mutual fund overall, because the Morningstar data has a ‘survivorship bias.’ The Morningstar data used only included mutual funds that were in business throughout the entire 19-year period. Mutual funds that were such poor performers [...]