How Many Funds Do You Really Need To Diversify?
Ask Real Deal Retirement
I have seven mutual funds in my retirement savings account that invest in a broad range of stocks (large-, mid-, small-caps, domestic and international) and bonds, plus real estate and gold. I’m now looking to add an eighth fund or ETF to my portfolio. Any recommendations? —Joseph
I’m sure there are people out there who would be more than willing to point to all sorts of funds and ETFs you could add to your portfolio: smart beta funds, thematic ETFs, low volatility funds. There’s even an ETF designed to capitalize on the ETF industry itself.
But I’m of the less-is-more school. So my recommendation to you is to slow down, take a deep breath and ask yourself this simple question: Do you really need to add more funds to your portfolio?
When you’re building a portfolio for retirement—or any other purpose, for that matter—your goal shouldn’t be to load up with as many different types of investments as you can (although you can certainly get that impression given the constant flow of new and often gimmicky funds and ETFs that financial services funds churn out).
Rather, your aim should be build a well-diversified group of funds that can help you harness the long-term wealth-building power of the financial markets in a way that’s consistent with your financial needs and tolerance for risk. The idea is to assemble a portfolio that can generate the returns required to achieve your financial goals, but won’t be so volatile that you’ll be tempted to jettison funds in a panic when the market goes through one of its inevitable severe setbacks.
Fortunately, you don’t need a whole lot of funds to do that. For example, with just two funds—a total U.S. stock market index fund and a total U.S. bond market index fund—you would have exposure to all sectors of the stock and bond markets, or large-, mid- and small-cap shares in the case of stocks and both government and corporate investment-grade issues in the case of bonds.
I think you could stop there and have a broadly diversified portfolio that should get you to and through retirement. But if you want to go the extra mile, you could also put, say, 15% to 30%, of your stock holdings into an international stock fund and a similar portion of your bond stake into an international bond fund for additional diversification and to ensure your portfolio’s performance isn’t completely dependent on the fortunes of the U.S. financial markets.
You appear to have pursued a version of this strategy, although with more funds presumably because you’ve chosen to invest in separate funds specializing in large, midsize and small stocks respectively rather than buy one fund that includes all such shares. I prefer the total stock market fund approach I described above rather than separate funds for large-, mid- and small-cap stocks because it keeps things simpler and requires less monitoring and managing of one’s portfolio. But if you’re up to the extra effort, your approach can work too.
You’ve also gone two steps further by adding a real estate and gold fund. Frankly, I don’t think these additions are absolutely necessary. But as long as they’re a minor part of your holdings, I don’t see a problem including them.
The main point, though, is that it seems you have more than adequate diversification to generate the gains you’ll need for a secure retirement. If you start throwing yet more funds into your current mix, I’d say you run the risk of turning your portfolio into an unwieldy mishmash of overlapping holdings that don’t work together as a coherent whole. In short, you stand a good chance of “di-worse-ifying” rather than diversifying.
But while you should think long and hard before adding an eighth (or ninth or tenth) fund to your portfolio, there are a few other things I think you can and should that might improve your portfolio’s performance.
First, I’d recommend you check to ensure you have a mix of stocks and bonds that balances growth vs. safety. Generally, you want to lean more toward stocks when you’re younger and have lots of time to rebound from market setbacks. You can then shift more toward bonds as you age and become more concerned about preserving your retirement nest egg. There’s no official stocks-bonds mix that’s right for every person of a given age. Some people are more comfortable with investing risk than others. But if you go to Vanguard’s risk tolerance-asset allocation questionnaire and answer its 11 questions, you’ll come away with a suggested stocks-bonds mix that makes sense given how much risk you feel you can handle and how long your money will be invested.
Your next step is to make sure that your stock and bond holdings generally reflect the makeup of the stock and bond market overall. For example, large-company stocks account for roughly 70% of total stock market value, while midcaps and small-caps represent about 20% and 10% respectively. Your holdings don’t have to mirror these percentages exactly. But if you want a truly diversified portfolio with a risk profile largely in line with that of the market overall, then you don’t want your portfolio’s proportions to be too far off either.
To see how your stock and bond holdings compare to the stock and bond market overall, plug your funds’ names or ticker symbols into the quote box at the top of any Morningstar page and then click on the Portfolio tab. For stock funds you’ll get, among other things, a breakdown of your funds’ holdings by size. In the case of bond funds you’ll get a breakdown by credit quality and type of issue (Treasury, other government, corporate).
You can then insert the ticker symbols for index funds that track broad domestic and international stock and bond markets benchmarks–for example, Vanguard’s total U.S. stock market index, total international stock market index, total bond market index and total international bond market index funds—and get similar breakdowns. By comparing the stats of your fund to those of funds that track the broad market, you can see whether your portfolio’s composition is roughly in synch with the stock and bond market overall.
Finally, I’d suggest you review what you’re currently paying in annual fund fees. Paying even an extra half a percentage point or so in yearly investment expenses can reduce the value of your nest egg by $100,000 or more over the course of a career, so you want to take care not to overpay. You can see how your funds’ fees compare to the average for its category by putting its name or ticker symbol into Morningstar’s Quote box and then selecting the Expense tab. If your funds’ fees are above average, you can screen for funds with lower costs at Morningstar’s Fund Screener. Or you can simply stick to low-cost index funds and ETFs, some of which charge as little as 0.10% a year in annual expenses.
Bottom line: If you really want to increase the chances that your investments will help you achieve a secure retirement, I suggest you go through the process I’ve described above and don’t assume that more is better when it comes to funds.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at email@example.com. You can tweet Walter at @RealDealRetire.