The 5 Percent Rule of Investment Allocation

Diversification Basics for Building a Portfolio of Mutual Funds

percentage
Don't put too high of a percentage of your savings into one mutual fund.. Getty Images

How much of one investment security is too much? For proper diversification, to obtain reasonable returns while minimizing risk, pay close attention to the 5 Percent Rule of Investment Allocation. 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 Portfolio

  • Asset Class: An asset is something that is 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: Asset allocation describes how investment assets are dividend into the 3 basic investment types -- stocks, bonds and cash -- within an investment portfolio. For a simple example, a mutual fund investor might have 3 different mutual funds in her investment portfolio: Half of her 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.​
  • Investment Securities: Securities are financial instruments that are normally traded in financial markets. They are divided into two broad classes or types: 1) Equity Securities (aka equities) and 2) 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 sub-categories that further describe the investment style of the fund.​
  • Sector Funds: Sector Funds focus on a specific industry, social objective or sector such as health care, real estate or technology. Their investment objective is to provide concentrated exposure to specific industry groups, called sectors. Mutual fund investors use sector funds to increase exposure to certain industry sectors they believe will perform better than other sectors. By comparison, diversified mutual funds--those that do not focus on one sector--will already have exposure to most industry sectors. For example, an S&P 500 Index Fund provides exposure to sectors, such as health care, 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 (and Pass) the 5 Percent Rule of Investment Allocation

    A simple example of the 5% rule is where an investor builds their own portfolio of individual stock securities. For example 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 their 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 (e.g. Gold), that the investor may not be aware of unless they read the fund's prospectus or they use one of the best 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 health care, real estate, utilities and gold, you simply keep your allocation to 5% or less for each.

    Example Mutual Fund Portfolio Using the 5 Percent Rule

    Keep in mind that your allocation to one mutual fund can be significantly higher than 5% if the fund itself does not break the 5 Percent Rule. For example, a 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.

    Here is an example core and satellite portfolio, which passes the 5% rule, using index funds and sectors:

    65% Stocks
    25% Vanguard 500 Index (VFINX)
    15% iShares MSCI ACWI ex US Index (ACWX)
    10% iShares Russell 2000 Index (IWM)
    5% Utilities Sector SPDR (XLU)
    5% T. Rowe Price Health Sciences (PRHSX)
    5% iShares Cohen & Steers Realty Majors (ICF)

    25% Bonds
    25% Vanguard Total Bond Market Index (VBMFX)

    10% Cash
    For cash, find a good money market fund at your broker.

    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.

    Continue Reading...