The 5% rule for investing is a general investment philosophy that recommends allocating no more than 5% of your portfolio to any single investment. This rule encourages investors to use proper diversification, helping to achieve reasonable returns while reducing risks.
Definitions of Terms for Building a Mutual Fund Portfolio
How many mutual funds is too many? The short answer is “it depends.” Factors such as the type of investment, investment goal, and the investor’s risk tolerance should be considered.
When building a mutual fund portfolio, you should take into account the different types of assets and various types of mutual funds. This will help determine the amount of assets or the type of mutual fund to allocate in your portfolio.
How to Use the 5% Rule for Investing
In a simple example of the 5% rule, an investor builds a portfolio of individual securities. An investor can exceed the 5% rule by building a portfolio of 20 stocks. However, many investors use mutual funds, which are assumed to be diversified already, but that is not always the case.
One benefit of mutual funds is their simplicity. However, the 5% rule can be broken if the investor is not aware of the assets within the fund. For example, a mutual fund investor could easily exceed the 5% rule by investing in one of the top S&P 500 index funds, as the total number of assets is at least 500 stocks, each representing 1% or less of the fund’s portfolio. However, some mutual funds have large concentrations of stocks or bonds or other assets, such as precious metals (like gold), which investors may not be aware of unless they read the fund’s prospectus or use one of the websites to research mutual funds.
Investors should also apply the 5% rule to sector funds. For instance, if you want to diversify with specialized sectors such as healthcare, real estate, and utilities, you should keep your allocation for each sector to 5% or less.
Mutual Fund Portfolio Using the 5% Rule for Investing
Your allocation to a mutual fund can be much higher than 5% if the fund itself does not break the 5% rule. For example, a good portfolio structure is the core and satellites structure, which is a strategy where you choose a “core” fund, such as an S&P 500 index fund, with a large allocation, such as 40%, and build around it “satellites,” allocating each between 5% and 20%. Index funds are considered good to use in the core and satellites because they are broadly diversified.
This typical core and satellites portfolio passes the 5% rule, using index and sector funds:
- 65% Stocks
- 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)
- 25% Bonds
- 25% Vanguard Total Bond Market Index Admiral Shares (VBTLX)
- 10% Cash
- Find a good money market fund to have
Logic
Sector funds (utilities, healthcare, and real estate) received a 5% allocation because these mutual funds focus on one particular type of stock, which can lead to higher risk levels. Mutual funds that carry high risks should generally receive a lower allocation. Other mutual funds can generally receive a higher allocation.
Frequently Asked Questions (FAQs)
What is the allocation of a passive investor’s portfolio?
The allocation of a passive investor’s portfolio will change as the market changes. For example, a person investing passively in an S&P 500 fund in 2021 allocates more than a quarter of their portfolio to the information technology sector. Healthcare is the next largest allocation, accounting for about 13% of the S&P. These distributions are not permanent and will change as market sentiment shifts regarding industries.
What
What is the best type of allocation for international investment?
International investment can be considered a broad category like bonds or domestic stocks. It is common for investors to allocate less to international stocks compared to domestic stocks, but these are just preferences. International investment may provide more diversification, but the international index like MSCI World has not historically performed well compared to domestic indices like the S&P 500.
The Balance does not provide tax, investment, or financial advice. The information is provided without regard to the investment goals or risk tolerance or financial circumstances of any specific investor and may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risks, including the risk of loss of capital.
Source: https://www.thebalancemoney.com/the-5-percent-rule-of-investment-allocation-2466542
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