by Archie M. Richards, Jr., CFP^®
May 1, 2006

Irwin writes, "My son's IRA, worth $178,000, is managed by a large mutual fund family for a fee of 1 percent. They've chosen 21 funds. Isn't that too many?"

It certainly is, Irwin. Diversification is important, of course. But if the manager is buying many actively-managed funds, diversification is probably not increased; it's reduced. Actively-managed funds like to buy what's hot. They therefore tend to own the same securities.

Some actively-managed funds engage in "style shift." Mutual funds, you see, don't disclose what they own between reporting periods. During those in-between periods (which is most of the time), some funds sell the stocks they're supposed to own and buy the stocks that are "moving." This deception also reduces diversification.

If the manager is switching to funds that beat the averages last year, this is an excellent way to obtain poor results this year.

Allocation among various asset classes is essential. But with such confusion, it's impossible to figure out exactly how much of each asset class your son holds. What are his proportions of growth and value stocks? Big and small stocks? Various regions of foreign stocks? REITs? Bonds? Not knowing the answers makes it impossible to invest in the most desirable way.

In my Suggested Portfolios (archierichards.com), I recommend 9 asset classes. The addition of many more doesn't add enough benefit to make the effort worthwhile. Or the fee either.

Finally, as you know from this column, annual rebalancing is an essential part of good investing. But rebalancing among 21 funds is like pushing a boulder uphill.

Contrast all this with index funds. Each one owns most, if not all, of the available securities of a particular asset class, with no style drift. Your son should own a small number of well-chosen index funds. Using the spreadsheet in my website, he can rebalance himself. With no extra fee, his costs would fall, his risks would diminish, and his long-term returns would improve.

Jim writes, "Two years ago, I invested $85,000 in a variable annuity. The investments have grown to $105,000. I expect to start making withdrawals in 10 years. Was my timing right in buying the policy?"

Your compound return, Jim, has been 11 percent a year. If that's net of costs, your record is terrific.

But the costs of variable annuities are particularly high. Eventually, the taxes are high, too, since withdrawals of earnings are taxed only as ordinary income. The low tax rates applying to long-term capital gains are forfeited.

You'll probably have to pay a substantial redemption fee if you withdraw. I suggest redeeming anyway. Buy no-load index funds or ETFs whose operating costs, transaction costs, and tax costs are much lower. You can continue exercising your investment skills, but you'll keep more of the money.

If you own a commercial real estate property for investment and you'd like to get out of it to buy another, do not just sell the property outright. You'll pay capital gains and probably other taxes on the sale.

Instead, take advantage of IRS Code 1031, which enables you to defer taxes by exchanging your investment property for another of "like kind." If the two properties are equal in value, no cash passes and the taxes are completely deferred. If the values are unequal, which is more likely, a 1031 exchange is still worthwhile.

But don't try this on your own. The tax rules are many, and the complexities are great. Use what the IRS calls a "qualified intermediary." To find one, visit the website of The Federation of Exchange Accommodators. Select an intermediary that's had plenty of experience.