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)?

Investing, Asset Allocation, Mutual Funds
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July 2017

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.

Good luck! 

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