You may have heard about the wisdom of diversification when it comes to investing. But how many mutual funds do you need to achieve it? The answer begins with three words: It depends on...
You may find sufficient diversification in just one fund. But you may need many funds to diversify your assets.
- The correct diversification depends on your objectives and your risk tolerance.
- Three or four mutual funds should be the bare minimum if you have low or moderate risk tolerance.
- The "core and satellite" design strategy is a method that involves owning many smaller investments along with one "core" mutual fund into which you've put most of your money.
Your Investment Objective
Your investment objective is your goal for how your portfolio will serve your financial needs. This is long-term growth to fund retirement for many people. But others may already be retired, and this would change their objective. They're looking for current income and long-term growth. Still others may want to simply preserve the asset level they have at the present time. They're more interested in safety than growth or income.
Your objective will dictate what asset classes and security types you should to meet the purpose of your portfolio. But you'll probably need more than one mutual fund to do it.
Diversification and Risk Tolerance
Risk tolerance is an investing term that relates to the amount of market risk you can tolerate with regard to ups and downs. You'd be willing to hold on to your funds when they're declining in value, even in a severe bear market, if you have a high tolerance for risk.
It's often riskier to hold just one or two mutual funds if they're stock funds. It's true that these can perform well over the long haul. But they can have extreme ups and downs—called volatility—in the short term.
A risk tolerance questionnaire can help if you don't know just how much risk you can handle. It will ask you a series of questions with various market scenarios. You can predict your reaction to them. This can help you decide the mutual funds that best fit your goals.
Mutual Fund Types
It's best to hold at least three or four mutual funds with different styles and objectives if you're like most investors. They should reduce volatility by combining fund types that don't share the same features. Stock funds may decline a great deal in value in a bear market. But bond funds can hold their value or even rise in value in the same market.
There are two major types of mutual funds: stock funds and bond funds. Stocks and bonds are also two of the three major asset classes. You can also invest in money market funds. These would represent the third asset class: cash.
On the simplest level, diversification means that you invest in at least two mutual funds—one stock fund and one bond fund. Money market funds can also be part of a portfolio if you need quick access to cash, and if you have a low tolerance for risk.
You'll need more stock funds than bond funds if you have a moderate to high tolerance for risk and a long-term growth goal.
Mutual Fund Portfolio Construction
You can invest in just one fund if you prefer. But it's wise to build a portfolio. Manage it according to your unique needs. You can take advantage of years of theory to build one that is diversified and suited to your own needs.
One portfolio theory can be simplified into a common and time-tested design known as "core and satellite." This structure is just as it sounds. You would begin with the "core." This will often be a large-cap stock index fund. It will represent the largest portion of your portfolio. Build around the core with "satellite" funds. These will each represent smaller portions of your portfolio.
The core and satellite portfolio would be right for a long-term investor with medium risk tolerance. The asset allocation is 65% stocks, 30% bonds, and 5% cash/money market sorted like this: 40% large-cap stock (index), 10% small-cap stock, 15% foreign stock, 30% intermediate-term bond, and
05% cash/money market
This mix is well diversified. Each fund has its own investment style that's not too similar to the other funds. This portfolio is likely to produce average returns of 5% to 8% in the long term, based on historical averages.
The ideal number is often between three and five funds. You may be sufficiently diversified with just one fund in some cases. It's rare that you'd need to have more than 10 funds.
NOTE: The information on this site is provided for discussion purposes only. It should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.