You've heard about the wisdom of diversification but how many mutual funds do you need to be diversified? As is the case with most financial questions like this, the answer begins with two words: It depends. An investor may find sufficient diversification in just one fund or they may need several funds to diversify their investment assets.
Diversification and Your Investment Objective
Your investment objective is the purpose a particular portfolio serves your financial needs. For most people, the purpose of their investment portfolio is long-term growth to fund retirement. Others may already be retired and are looking for current income and long-term growth. And some investors want to simply preserve what they have now and are more interested in safety than growth or income.
Once the objective is determined, it will then dictate what particular asset classes and security types are needed to fulfill the purpose of the portfolio. However, it is likely that no matter the investment objective, you'll need more than one mutual fund to do it.
Diversification and Your Risk Tolerance
Risk tolerance is an investing term relating to the amount of market risk, especially the volatility (ups and downs), an investor can tolerate. For example, if you have a high tolerance for risk, it means you are willing to hold on to your mutual funds when they are declining in value and even amidst a severe bear market.
It is generally more risky to hold just one or two mutual funds, especially if they are stock funds, which can perform well long term but can have significant fluctuations (ups and downs), or what is called volatility, in the short term.
If you do not know your tolerance for risk, a risk tolerance questionnaire can help by asking several questions with various market scenarios, where you can predict your reaction to them and thus help determine the best fit mutual funds accordingly.
Diversification and Mutual Fund Types
If you are like most investors and have a moderate to low tolerance for risk, it is best to hold at least three or four mutual funds with different styles and objectives. If properly diversified, they will reduce volatility by combining fund types that do not share the same qualities. For example, in a bear market, stock funds may decline significantly in value but bond funds can hold their value or even rise in value in a bear market.
On the most basic level, there are two major categories of mutual funds—stock funds and bond funds. Stocks and bonds are also two of the three major investment asset classes. You can also invest in money market funds, which represent the third asset class—cash.
Therefore diversification on the most simple level is to invest in at least two mutual funds—one stock mutual fund and one bond mutual fund. Money market funds can also be an appropriate part of a portfolio, especially if there is a need for liquidity (quick access to cash) and/or the investor has a low tolerance for risk.
Generally, and assuming you have a moderate to high tolerance for risk and a long-term growth objective, you will need more stock funds than bond funds in your portfolio.
Diversification and Mutual Fund Portfolio Construction
While it is possible to invest in just one fund, investors are wise to construct their own portfolio and manage it according to their specific needs. You can take advantage of years of portfolio theory to build a portfolio that is diversified and suited to you personally.
Fortunately, this portfolio theory can be simplified into what is called a common and time-tested portfolio design called core and satellite. This structure is just as it sounds: You begin with the "core," which will usually be a large-cap stock index fund, which represents the largest portion of your portfolio and build around the core with the "satellite" funds, which will each represent smaller portions of your portfolio.
Here is an example of a core and satellite portfolio that is appropriate for a long-term investor with moderate (medium) risk tolerance (the asset allocation is 65% stocks, 30% bonds, 5% cash/money market):
40% Large-cap stock (index)
10% Small-cap stock
15% Foreign stock
30% Intermediate-term bond
05% Cash/money market
This mix of mutual fund types and money market fund is well-diversified, which means that each fund has a unique investment style that is not highly correlated (too similar) to the other funds in the portfolio. In the long term, this portfolio is likely to produce average returns of 5% to 8%, based on historical averages. For other portfolio models see:
To summarize, and to finally answer the question of how many mutual funds is best, it is likely that the ideal number is somewhere between three and five funds. In some cases, an investor may be sufficiently diversified with just one fund. It's rarely necessary to have more than 10 different funds.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.