The 5 Percent Rule of Investment Allocation
Diversification Basics for Building a Portfolio of Mutual Funds
The 5% rule of investing is a general investment philosophy that suggests an investor allocate no more than 5% of their portfolio to one investment security. This rule encourages investors to use proper diversification, which can help to obtain reasonable returns while minimizing risk.
Before explaining the 5% rule further, let's first define a few investment terms you need to know for building a portfolio of mutual funds.
Definitions of Terms for Building a Mutual Fund Portfolio
How much of one mutual fund is too much? The short answer is, "It depends." Factors to consider include investment type, the investor's investment objective, and the investor's risk tolerance.
When building a portfolio of mutual funds, keep in mind the various types of assets and the different types of mutual funds. This will help in determining how much of one asset or one mutual fund type to allocate in your portfolio.
Here are the basics to know:
An asset is something owned or capable of being owned. Examples include financial currency (money), stocks, bonds, gold, and real property. Asset classes, with regard to investing, are the three basic types of assets: stocks, bonds, and cash.
Asset allocation describes how investment assets are divided into three basic investment types— stocks, bonds, and cash—within an investment portfolio. For a simple example, a mutual fund investor might have three different mutual funds in their investment portfolio: Half the money is invested in a stock mutual fund, and the other half is divided equally among two other funds—a bond fund and a money market fund. This portfolio would have an asset allocation of 50% stocks, 25% bonds, and 25% cash.
Securities are financial instruments that are normally traded in financial markets. They are divided into two broad classes or types: equity securities ("equities") and debt securities. Most commonly, equities are stocks. Debt securities can be bonds, certificates of deposit (CDs), preferred stock, and more complex instruments, such as collateralized securities.
Mutual Fund Categories
Mutual funds are organized into categories by asset class (stocks, bonds, and cash/money market) and then further categorized by style, objective, or strategy. Learning how mutual funds are categorized helps an investor learn how to choose the best funds for asset allocation and diversification purposes. For example, there are stock mutual funds, bond mutual funds, and money market mutual funds. Stock and bond funds, as primary fund types, have dozens of subcategories that further describe the investment style of the fund.
Sector funds focus on a specific industry, social objective, or sector such as healthcare, real estate, or technology. Their investment objective is to provide concentrated exposure to one of ten or so business sectors. Each sector is a collection of several industry groups. For example, the energy sector may include oil and gas refinery companies, production companies, and exploration companies. Mutual fund investors use sector funds to increase exposure to certain industry sectors they believe will perform better than others. By comparison, diversified mutual funds—those that do not focus on just one sector—will already have exposure to most industry sectors. For example, an S&P 500 Index Fund provides exposure to sectors such as healthcare, energy, technology, utilities, and financial companies.
Mutual Fund Holdings
A mutual fund's holdings represent the securities (stocks or bonds) held in the fund. All of the underlying holdings combine to form a single portfolio. Imagine a bucket filled with rocks. The bucket is the mutual fund, and each rock is a single stock or bond holding. The sum of all rocks (stocks or bonds) equals the total number of holdings.
How to Use the 5% Rule of Investing
In a simple example of the 5% rule, an investor builds their own portfolio of individual stock securities. The investor could pass the 5% rule by building a portfolio of 20 stocks. (At 5% each, total portfolio equals 100%.) However, many investors use mutual funds, which are assumed to be well diversified already, but this is not always the case.
One of the many benefits of mutual funds is their simplicity. But the 5% rule can be broken if the investor is not aware of the fund's holdings. For example, a mutual fund investor can easily pass the 5% rule by investing in one of the best S&P 500 Index funds, because the total number of holdings is at least 500 stocks, each representing 1% or less of the fund's portfolio. But some mutual funds have heavy concentrations of stocks, bonds, or other assets, such as precious metals (gold, for example), that investors may not be aware of unless they read the fund's prospectus or use one of the online sites to research mutual funds.
Investors should also apply the 5% rule with sector funds. For example, if you wanted to diversify with specialty sectors, such as healthcare, real estate, and utilities, you would simply keep your allocation to 5% or less for each.
Mutual Fund Portfolio Using the 5% Rule of Investing
Your allocation to one mutual fund can be significantly higher than 5% if the fund itself does not break the 5% rule. For example, one good portfolio structure to use is the core and satellite portfolio, which is a strategy of choosing a "core" fund, such as an S&P 500 Index fund, with a large allocation percentage, such as 40%, and build around it with "satellite" funds, each allocated at around 5% to 20%. Index funds are good to use for both the core and the satellites, because they are broadly diversified.
This sample core and satellite portfolio passes the 5% rule, using index funds and sectors:
- 25% Vanguard 500 Index Admiral Shares (VFIAX)
- 15% iShares MSCI ACWI ex US Index (ACWX)
- 10% iShares Russell 2000 ETF (IWM)
- 5% The Utilities Select Sector SPDR (XLU)
- 5% T. Rowe Price Health Sciences (PRHSX)
- 5% iShares Cohen & Steers REIT ETF (ICF)
Find a good money market fund at your broker.
The sector funds (utilities, healthcare, and real estate) received a 5% allocation, because these particular mutual funds concentrate on one particular type of stock, which can create higher levels of risk. Higher-risk mutual funds should generally receive lower allocation percentages. Other mutual funds can receive higher allocation percentages.
The Balance does not provide tax or investment advice or financial services. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.