You may have heard of the wisdom of diversification when investing. But how many mutual funds do you need to achieve that? The answer starts with three words: it depends.
Your Investment Objective
Your investment objective is your goal for how your portfolio serves your financial needs. This goal may be long-term growth to fund retirement for many people. But some may have already retired, which changes their objective. They are looking for current income and long-term growth. However, some may want to maintain the asset level they currently have. They are more concerned about security than growth or income.
Diversification and Risk Tolerance
Risk tolerance is a term related to how much market risk you can withstand concerning ups and downs. You will be willing to hold onto your money when its value declines, even in a severe bear market, if you have a high risk tolerance.
It is often more risky to invest in only one or two funds if they are equity funds. It is true that these funds can perform well over the long term. But they can experience significant volatility in the short term.
A risk tolerance questionnaire can help if you don’t know how much risk you can handle. It will ask you a series of questions with different market scenarios. You can predict your reaction to them. This can help you determine the best mutual funds that align with your goals.
Types of Mutual Funds
It is best to hold three or four mutual funds with different styles and objectives if you are like most investors. You should reduce volatility by combining types of funds that do not share the same characteristics. Equity funds can significantly decline in value in a bear market. But bond funds can hold their value or even rise in the same market.
There are two main types of mutual funds: equity funds and bond funds. Stocks and bonds are also among the three main assets. You can also invest in money market funds. These represent the third category: cash.
At its simplest, diversification means investing in at least two mutual funds – one equity fund and one bond fund. Money market funds can be a part of the portfolio if you need quick access to cash, and if you have a low risk tolerance.
You will need more equity funds than bond funds if you have a medium to high risk tolerance and a long-term growth objective.
Building a Mutual Fund Portfolio
You can invest in a single fund if you prefer. But it is wise to build a portfolio. Manage it according to your unique needs. You can benefit from years of theory to build a diversified portfolio suitable for your needs.
The portfolio theory can be simplified into a well-known and proven design called “core and satellite”. This structure is exactly as it sounds. You will start with the “core”. This will typically be a large-cap stock index fund. It will represent the bulk of your portfolio. Build around the core with “satellites”. Each will represent smaller parts of your portfolio.
A core and satellite portfolio will suit a long-term investor with a medium risk tolerance. The asset allocation is 65% stocks, 30% bonds, and 5% cash/money market arranged as follows: 40% large-cap stocks (index), 10% small-cap stocks, 15% foreign stocks, 30% intermediate-term bonds, and 5% cash/money market.
This mix is well-diversified. Each fund has its own investment style that does not closely resemble the other funds. This portfolio is likely to produce average returns ranging from 5% to 8% over the long term, based on historical averages.
You can
Review the aggressive mutual fund portfolio and another portfolio from a different province for additional models.
The ideal number is often between three and five funds. In some cases, you may have enough diversification with just one fund. It is rare to need more than 10 funds.
Note: The information provided on this site is for discussion purposes only. It should not be construed as investment advice. In no event does this information represent a recommendation to buy or sell securities.
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Sources:
– Annuity.org. “Risk Tolerance.”
– First National Bank. “Core and Satellite Strategy.”
Source: https://www.thebalancemoney.com/how-many-mutual-funds-should-you-have-to-be-diversified-2466602
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