Investment advisors are often asked how many mutual funds they should have in a 401(k) or another long-term portfolio to maintain diversification and thereby limit their risk and potential investment losses.
Experts claim that a diversified portfolio consists of eight to 60 stocks. Given that the average mutual fund is a basket of 36–1,000 stocks, you can technically achieve a diversified portfolio with only one fund. But investors who prefer greater diversification set the limit at eight.
The right number of mutual funds for you depends on several factors, including your investment objective and tolerance for risk. If you're wondering how many funds to include in your portfolio, there are a few strategic principles of diversification you should follow.
One study of sample portfolios found that a portfolio with around 48 underlying stocks eliminated 98% of market risk.
Basics of Diversification With Mutual Funds
Diversification with mutual funds refers to the spread of money across different investments.
The sage expression "don't put all your eggs in the same basket" describes the essence of diversification because it illustrates the need to spread your risk across 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 mistake with diversification: They think that diversification can be achieved if they simply spread their money across several different mutual funds. But if you put your eggs into different baskets that share virtually the same characteristics, that's not diversification.
When deciding on how many mutual funds and which funds you should have in your portfolio, aim for diversification in your portfolio at two levels: across asset classes (like stocks, bonds, and cash) and within asset categories (industries and companies).
The underlying securities in the mutual funds you hold can be as big a determinant of how diversified your portfolio is as the number of funds you hold.
Diversification Across Asset Classes
A portfolio that is exclusively invested or too heavily weighted in stocks might sound good in theory because stocks can rise dramatically in price during an economic boom, and you might reap the rewards in the form of higher returns. But it's risky because it subjects your portfolio to outsized losses in the stock portion of your portfolio—and significant declines in the overall value of your portfolio—when the market declines. On the flip side, investing too much in cash or otherwise incorporating too little risk in your portfolio may mean that it doesn't generate sufficient returns to meet your goals.
To balance risk and reward, spread your money across the different asset classes you choose (stocks, bonds, and cash, for example). The specific spread you choose should factor in these key criteria:
- Investment goal: You might be investing for capital appreciation (growth of the investment over time) or income, for example. If capital appreciation is your goal, you might want to weight your portfolio more heavily toward stock than someone who wants to draw a steady income.
- Risk tolerance: Risk refers to the potential to lose the money you invest. Assets that carry greater returns also tend to come with greater risk. If you have a high risk tolerance, you might put more of your money in stock; if you're extremely risk-averse, you might want to put more of your money in money market funds.
- Time horizon: This is the period over which you plan to invest. Generally, investors with a long time horizon can take more risks and invest more heavily in stocks than those who only intend to invest over a short period (someone nearing retirement, for example).
Asset Category Diversification
Although you may have several different funds in your portfolio, if some or all of them have the same or similar holdings, your portfolio has a major flaw known as fund overlap.
For example, let's say that you divide your money equally between four different mutual funds; each represents 25% of your portfolio. Each fund has a different name and therefore appears to have different objectives. Suppose that 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 has many of the same company holdings as the first three, in which case they are too similar to provide the diversification you need to spread risk, or to successfully "put your eggs into different baskets."
To avoid making this mistake, pick mutual funds with holdings in different asset categories. For example, a simple four-fund allocation that is diversified could include one large-cap stock fund, one small-cap stock fund, one international stock fund, and one bond fund.
Each of these will likely hold completely different securities. But it's still important to review the underlying holdings of any funds you add to your portfolio to ensure that they don't have overlap.
How Many Mutual Funds You Should Hold
There's no magic number of funds to keep in a 401(k) or another portfolio for long-term investing. The right number of investments is one that ensures diversification but also factors in your investment approach.
If you prefer low-effort investing, consider buying a single fund. If you are prepared for more administrative work when it's time to rebalance your portfolio, choosing up to eight offers an opportunity to increase the number of asset categories you include in your portfolio. No matter how many funds you settle on, you can likely put together a portfolio that accommodates your choice:
- One fund: All-in-one funds like target-date funds for investors retiring in a certain year make it possible to invest in just one fund and be diversified.
- Two funds: Increasingly popular two-fund portfolios with a stock fund and a bond fund may allow for increased diversification.
- Four funds: A four-fund allocation could include a domestic stock fund, a domestic bond fund, an international stock fund, and an international bond fund.
- Eight funds: Opt for large, mid-size, and small domestic stock funds, international and emerging market stock funds, two bond funds, and a money market fund to build a more complex eight-fund portfolio.
Frequently Asked Questions (FAQs)
What are the main types of mutual funds?
There are four categories of mutual funds: equity, money market, fixed income, and hybrid. Equity funds are also referred to as stock funds. These funds are usually focused on publicly traded companies, and their values can rise and fall quickly over a short period. Money market funds are among the safest funds options as they focus on short-term, high-quality investments made by the government, U.S. corporations, and state/local governments. Fixed income funds are also called bond funds. They provide a profit through dividend payments focused on government and corporate debt. Last but not least are hybrid funds that combine different funds to account for the specific investor's needs.
What are the best mutual funds?
The best mutual funds can ride out a weak economy and bring in higher returns in the long game. When we pick the best mutual funds, we look for a few characteristics to know they are good long-term investing prospects. These include a low starting point, diversified funds with a strong balance among their assets, and those from different sectors. If you are looking for the best mutual funds for retirement, we would also suggest those that provide a higher comfort level and relatively low risk.