Q: I have an $800,000 portfolio. How many mutual funds should I own? — Lynn
A: The optimal number of funds will vary depending on your time horizon, tolerance for risk, and exactly what kinds of funds you choose.
That said, if you’re looking to build and manage a diversified portfolio of exchange-traded funds (ETFs) or index mutual funds on your own, a good number is either six or 10, says Bill Valentine, president of Valentine Ventures, a Bend, Ore.-based wealth management firm. This is true, he says, whether you have $800,000 or a more modest portfolio.
Anything more than that many funds will “do nothing for diversification,” Valentine says, and will only add cost and complexity to your strategy.
Let’s start by discussing the whole notion of diversification. To get the best balance of risk and reward, you’ll want to invest in lots of securities across many different asset classes. Investing in ETFs or index mutual funds takes care of the first critical point of diversification since most such funds are composed of hundreds of different securities.
Even so, a single fund focused on a single asset class won’t provide you adequate diversification. Likewise, investing in six funds that all hold, say, large blue chip U.S. companies won’t improve returns, and may even detract from them.
“It’s important to blend asset classes than don’t act too similarly to each other, otherwise you’ll lose the benefit of diversification,” says Valentine.
If you’re young and have a long time horizon, you may not own bonds in your portfolio. Valentine says you’ll still want to spread your bets across six primary investment classes.
They include U.S. large cap stocks, U.S. small cap stocks, foreign developed-market stocks (shares of companies based in Europe and Japan), and foreign emerging-market stocks (shares of companies based in faster-growing economies such as like China and India).
And to diversify your equities, you’ll also want to consider owning a small amount in commodities and real estate investment trusts, or REITs.
Exactly how you slice the pie will depend on your specific time horizon and risk tolerance. Note: Valentine is not a proponent of owning bonds if you’re young, but most advisers recommend a small allocation to fixed income, even in a relatively aggressive portfolio.
Now, if you own bonds as part of your mix, you may want to add as many as four fixed-income funds to that mix.
Valentine recommends bond funds that give you exposure to: the broad U.S. fixed-income market (reflecting high-quality corporate and government debt), U.S. high yield bonds (which expose you to higher-yielding but lower-quality corporate debt), U.S. inflation-protected securities (to safeguard your holdings against rising consumer prices), and foreign bonds.
Again, the exact percentages will vary based on the specifics of your situation.