This is a common question among investors who know that diversification is always recommended for investment portfolios. They need diversification in order to be effective. However, while many professional financial advisors will tell you to diversify your portfolio into many different funds, there’s not as much industry-wide agreement about how many funds you should have in your overall portfolio.
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Spread your investment portfolio around different categories
Preferably, you won’t put your entire investment portfolio into one place but actually spread it around over a variety of different categories. These categories should have different objectives and investing across many reduces your broader risk.
Different kinds of funds might be focused on small growth, mid-value, or large growth, and they each provide unique objectives in terms of risk and reward.
Stocks and bonds are two different fund categories that each have their own scale of escalating risk.
From the safest at the top to the riskiest potential options, equity funds follow this scale:
- Large value
- Large growth
- Mid value
- Mid growth
- Small value
- Small growth
- International
- Sector
- Emerging markets
Bond funds also have a scale of risk, with the short-term bonds being the safest and emerging markets the riskiest:
- Short-term
- Government mortgage
- Intermediate-term
- Multisector
- Long-term
- High-yield
- International
- Emerging markets
The sheer number of available funds has grown tremendously given how there has been growth in terms of both style classifications and new specialty fund categories.
For instance, there might be international stock funds focusing on a particular continent or even a specific region.
Style classifications for stock and bond funds
In equity funds, style refers to how stocks are selected and the capitalization of those. Equity fund capitalization can be small, mid, or large, and the stock selection can be value, growth, or blended.
In bond funds, style refers to two things. One is the length of maturity, which can be long-term, intermediate, or short-term. The second is a measure of volatility, which might be high, moderate, or low.
Guidelines to do your own diversification process
Given all these possibilities, investors now have to navigate more fund choices than anyone before them. Use the following four guidelines to simplify your own diversification process:
1. Specify Your Particular Investment Objectives
Potential objectives might include your portfolio amount, risk tolerance, return objectives, and time horizon. These all give you clarity and focus regarding your overall investment strategy.
When your chosen funds are an accurate representation of your chosen objectives, then your investment plan should be effective.
2. Pick Quality Instead of Quantity
Unfortunately, many investors view diversification as he who with the most toys wins. However, putting your investment portfolio into too many funds can dilute it with funds that just don’t match their desired objectives.
3. Prevent Duplication
Part of making sure every fund you invest in is distinct is by simply avoiding duplication. You don’t need two or more funds that all feature identical objectives.
For instance, investing in a pair of large-cap value funds and then two more small-cap growth funds might technically be a four-fund portfolio, but it’s only two-fold diversification and not enough.
4. Less Is Better:
Most funds have anywhere from 50 to 200 or more different equities and bonds. That means that it only takes a handful of funds to diversify with effectiveness.
Every fund must have a specific purpose within your overall strategy
Typically speaking, the amount of your overall portfolio might determine how many funds you invest in. As the portfolio grows, you can diversify in more funds.
Having said that, personal preferences and situations do vary. One investor might be quite content with spreading their $100,000 portfolio over just five funds, whereas another investor with just as much money might look into eight or nine.
The one thing to always remember, no matter how many funds you include in your portfolio, is that effective diversification happens when you make sure every individual fund has a specific purpose that accommodates your overall strategy without duplicating what any other fund does.