How should I diversify mutual funds in my portfolio?
What diversification of mutual funds should I hold in my account to keep my portfolio growing at a stable rate? I know if I invest too heavily in index funds, and only index funds, when the market crashes, my portfolio will sink. How many funds and what funds is a good amount for diversification (i.e. 1 growth, 1 small cap index, 1 bond)?
Thank you for your question. It looks like you could use some guidance on how to build a portfolio before you invest your hard-earned money. My philosophy is that the best result for investors is when they focus on understanding their own tolerance for risk first. Then build a diversified portfolio that perfectly matches their own risk tolerance. Review your progress towards your goals. This creates a perfectly matched portfolio to their Risk Number and a systematic way to measure your progress and adjust along the way. This can be accomplished in three easy steps:
First, capture Your Risk Number. The first step is to answer a 5-minute questionnaire that covers topics such as portfolio size, top financial goals, and what you’re willing to risk for potential gains. This will pinpoint your exact Risk Number to guide the decision-making process.
Align Your Portfolio. After pinpointing your Risk Number, create a portfolio that aligns with your personal preferences and priorities, allowing you to feel comfortable with your expected outcomes. The resulting proposed portfolio will include projections for the potential gains and losses you should expect over time.
Meet Your Investment Goals. Review your progress toward your financial goals by building an Investment Map. When you finished this process, you’ll fully understand what is possible to increase the probability of success.
There are differing opinions on how to diversify a portfolio. We believe that it is impossible to predict how the market, or a particular asset class, is going to perform over a period of time, so we don't try. We suggest a globally diversified portfolio using low-cost index funds. The asset classes we recommend are US Stocks, International Stocks, Emerging Markets, Real Estate, Short-term High-quality Fixed Income, and Intermediate-Term High Quality Fixed-Income (bonds). I hope this helps.
Diversification is a concept that is often misunderstood. Even if many funds are held and the labels suggest that they appear to occupy different asset classes, the actual diversification may be qute different from the hoped-for diversification. Indeed, I had a client who had over 150 different holdings (assembled by himself), including stocks, ETFs, and open-end mutual funds. Just for example, there were more than a dozen energy holdings, which could easily be replaced by one ETF focusing on energy.
Proper diversification should encompass different asset classes as well as both domestic and international holdings. The simplest approach to the U.S. would be to hold a total stock market exchange-traded fund such as VTI (Vanguard Total Market Index), which includes small, medium, and large cap. This could be supplemented by VXUS (Vanguard Total International Market Index) and VBMFX (Vanguard Total Bond Market Index Fund) or AGG (iShares Barclays Aggregate Bond Fund), both of which cover a broad range of bonds.
This kind of approach will give you exceptionally broad diversification. Since there will be important equity components, the overall value will fluctuate, though most probably significantly less than stocks generally. But with the prospect of continuing increases in interest rates, the contribution from the bond side will be limited to a combination of stability and modest income. The days of substantial total return from bonds are over.
You may choose to have a broader selection of funds, though it is doubtful that more would be better.
Diversification is a great idea so I am glad you want to do so. To answer the question, I would ask, how much work do you want to do? If ultra simplicity is what you want, you could use as little as 3 vehicles: total US stock market, total foreign stock market, and a total bond vehicle. How you allocate to each will depend on your goals and risk tolerance. It is also very important that your allocation work to support your long term financial plan, meaning you understand how much risk you actually need to take, not what you think you can tolerate.
If you are more adventurous, as long as you have a sensible risk approach in line with that long term plan, then look to mix large, medium, and small stocks here and abroad and seek exposure in various bond vehicles. Examples: treasuries, investment grade corporates, mortgage backed, foreign bonds, and and even emerging market bonds. Why no junk bonds? Because they are highly correlated to stocks, so any exposure you have to these should come from you stock allocation.
This diversification would happen if you identify your various financial goals and invest according to your risk profile and investment horizon. Your fears are real and that is why you should access your risk profile before you proceed.
To diversify, you should consider Index or Bond Funds. Investing in securities and portfolios that will be able to track down various indexes over time is an excellent diversification of your investment in the long run. Fixed income solutions will also go a long way in protecting your portfolio against market volatility and uncertainty and don’t forget to keep building on the investment.