A 54-year-old woman recently asked me this question: "I have $70,000 invested in four funds,

(FEQIX) - Get Report

Fidelity Equity-Income,

(FCNTX) - Get Report

Fidelity Contrafund,

(FASMX) - Get Report

Fidelity Asset Manager and the

(FSMKX)

Fidelity Spartan Index 500. Is this a good portfolio?"

This investor's question is a common one from newcomers. It's not a good portfolio because too much overlap exists among these funds. Indeed, one of the chief mistakes investors make is to buy the same securities over and over again in different funds with different names. They then believe they're diversified.

Investors often think of funds as brand labels, such as Crest toothpaste or Tide, and they buy them as if the name represents something. That's a big mistake. Fund names are devised by the marketing folks at fund companies to appeal to your emotions, to convey strength or excitement or boldness or stability. It's your responsibility to find out what's really under the hood.

Similar Holdings, Similar Returns

I looked up these four funds and what I uncovered didn't surprise me much: The funds have similar holdings and have gotten similar recent returns.

First, I compared the returns for the past three months, one year and three years. The winner in this group is Asset Manager, which gained an average of 5.17% over the past three years, compared with 0.40% for the Spartan Index 500 and 3.75% for the other two.

Asset Manager is meant to be an asset allocation fund, and it has just 45% of its assets in stocks, 34% in bonds and 11% in cash. Over the past couple of years, the less held in stocks the better. In that sense, Asset Manager is the best diversifier in this woman's portfolio. The index fund is close to 100% in stocks, which explains its poor performance.

But we also need a sense of what's in the fund. This information is available under "Top Holdings," which shows the top 10 securities a fund holds. The lag in disclosure of this information is a big controversy in the fund industry. Funds are required to disclose it only twice a year, so the information is dated. Still, I think it gives a pretty good sense of what the fund goes after. And with an index fund, which has very low turnover, the top 10 stocks are unlikely to change.

What I found was that the three Fidelity-managed funds had similar holdings, such as

Citigroup

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,

ExxonMobil

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,

General Electric

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and

Fannie Mae

(FNM)

.

But Asset Manager bought three series of Fannie Mae bonds as its No. 2, No. 9 and No. 10 holdings, while the other two invested in the stock. All three portfolios were low in technology. The Index 500 holds

Microsoft

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,

IBM

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and

Intel

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, adding some technology to the portfolio.

Matching Zigs With Zags

What we really want to know, though, is how funds perform in the same environment. We want to find a fund that zigs when another zags. One of my favorite research devices is the charts, where you can compare performance of various stocks and funds.

There wasn't much diversification in this group. Equity-Income is a value fund, and the value component gave that fund a boost over Contra, a blend fund. Over the past year, Equity-Income was down just 3.15%, compared with a loss of 11.70% for Contra. But over the three-year period, their performance is identical.

Just for fun, I tried adding the

iShares Dow Jones U.S. Real Estate Index

(IYR) - Get Report

to the other funds and found that it went up this year while the others went down. That's what you're looking for in diversifying a portfolio.

The tough part about diversifying into real estate or bonds is that when stocks are on a tear, money that is not in stocks seems to be wasting away. You've got to tough it out and realize that the returns you're giving up are buying you safety. Certainly, over the past two years we've seen the value of this kind of diversification. Bonds beat stocks handily in 2001, and for the past three years as well.

A Better Option

That's why Asset Manager was the best part of this woman's portfolio. It holds a decent portion of bonds, as much as a good balanced fund such as

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Vanguard Wellington. So I think that fund's OK. Ditto for the Spartan 500 Index, which is a big-cap growth fund that tracks the performance of the

S&P 500

. But I don't think Equity-Income and Contra add anything to the mix.

A better option for her might be to put up to 50% in the Asset Manager fund, which invests 34% in bonds and holds an indexlike 685 stocks in its portfolio. Another 10% can go in a broad technology fund such as the

Nasdaq 100 Trust

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.

About 20% could go in a good value fund such as

(AMSTX)

Ameristock, which holds

Dell

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and

IBM

(IBM) - Get Report

, as well as

Bristol-Myers Squibb

(BMY) - Get Report

,

American Home Products

(AHP)

,

Sears

(S) - Get Report

and

Ford

(F) - Get Report

.

The final 20% could be split between a real estate index, such as IYR, and an energy fund, such as

(VGENX) - Get Report

Vanguard Energy.

That would reduce her stock exposure from a very aggressive 82% to something closer to 70% -- still aggressive for someone in her 50s. It would also improve the portfolio's diversification by increasing bond holdings from 9% to 17% and providing a better mix of stock asset classes.

I am not proposing this as an ideal portfolio so much as I am trying to point out the importance of diversification and of making certain that your funds overlap as little as possible. Many people resolve to clean up their portfolios in the new year. One good way to do that is to cut down on overlap.

At the time of publication, Mary Rowland owned or controlled shares in none of the equities mentioned in this column.