How Many Mutual Funds Should You Have?

How Many Mutual Funds Do You Need to Be Diversified?

Make sure you invest in the right number of funds for you. Getty Images

A question I am often asked is how many mutual funds is best for diversification purposes? When I give the two word answer, "it depends," I don't often receive a smile of satisfaction in return.

Therefore I thought it would be helpful to write this article on best diversification practices, specifically with regard to the number of mutual funds to buy to be diversified.

What Diversification Is and What It Isn't

The sage wisdom in the phrase, "don't put all your eggs in the same basket" does help describe the essence of diversification because it simply illustrates the need to spread your risk into several areas.

Put differently, if you put all of your money into one investment, you're probably not diversified.

But here's where investors often make their biggest mistakes with diversification: They think that buy spreading their money among several different mutual funds that their diversified. What if you put your eggs into different baskets but all of the baskets are nearly the same? That's not diversified!

For a more specific example, let's say you allocate your savings equally to four different mutual funds, where each holds 25% of your investment assets. Each fund has a different name and therefore appears to have different objectives. Let's say one is a growth fund, another is a growth and income fund, a third is an S&P 500 index fund, and a fourth is an international fund. It is possible that the first three funds are nearly identical and that the fourth one has many of the same holdings as the first three.

This general scenario of poor diversification is repeated more often than you think because it's been told to millions of people, as I illustrate clearly in another article I wrote, called Why Dave Ramsey Is Wrong On Mutual Funds. While each of the four fund types Dave "recommends" to his followers are not exactly identical, they are too similar to provide the kind of diversification that is necessary to spread risk, or to successfully "put your eggs into different baskets."

Avoid Fund 'Overlap'

Although you may have several different funds in your portfolio, the problem when some of them have too many similarities is illustrated by the investment term, overlap. To avoid overlap with mutual funds, be sure that your fund holdings are truly from different fund categories.

For example, a simple four-fund allocation that is diversified could include one large-cap stock fund, one small-cap stock fund, one foreign stock fund, and one bond fund. Each of these will likely hold completely different securities, as compared to each of the other funds. And notice I listed "foreign stock" rather than "international" stock. A foreign stock fund will typically invest 80% to 100% of its assets in stocks of companies outside the United States, whereas an international stock fund might have 50% or less of its holdings in foreign stocks and the remainder in US stocks.

If you want to be sure you're getting the investments you want, a good idea is to use index funds. For example, a foreign stock index fund like Vanguard European Stock Index (VEURX) only invests in European stocks, not US stocks.

The Ideal Number of Funds to Hold

While it is possible to invest in just one fund and be diversified, you'll need at least two but probably no more than 10 to be properly diversified.

If you invest in just two, you may choose a stock index fund and a bond index fund and achieve suitable diversification.

Therefore we end where we began: How many mutual funds is best? It depends...

See Also: How to Build a Portfolio of Mutual Funds