The Perfect Mutual Fund Portfolio

I probably don't need to convince many of you of the benefits of owning mutual funds. For investors that don't want to research, buy, sell, and keep track of dozens of individual stock holdings, funds are a great way to delegate the investment management function to a knowledgeable professional. All that time you otherwise would have spent building a stock-by-stock portfolio can be directed into other worthwhile pursuits, like gardening, stamp collecting, or building those little wooden ships inside of glass bottles.

But now the question remains -- exactly how many funds do you need to adequately diversify your portfolio?

Think outside the box
To help answer this question, the first place most investors look is that big, overarching industry icon, the Morningstar Style Box. For those of you not familiar with the Style Box methodology, this is Morningstar's system of classifying stocks or funds according to three capitalization ranges (small, medium, or large), and also by style, or fundamental characteristics (growth, blend, or value). Thus, there are nine possible combinations of funds: small growth, small blend, small value, mid-growth, mid-blend, mid-value, large growth, large blend, and large value. Each of the nine Style Boxes represents one of these categories.

Too often, the prevailing wisdom is that investors need to own at least one fund in each style box, so as to ensure exposure to each and every corner of the market. Following this line of thought, many folks end up buying three different small-cap funds, three mid-cap funds, and three large-cap funds to cover each contrasting investment style. And that's not even taking into consideration international stocks, bonds, and alternative asset classes. So it's easy to see how, all too soon, many investors can find themselves up to their ears in a dozen or more different mutual funds. Hey, wasn't investing in funds supposed to simplify your life? Remember all those ships-in-bottles you wanted to build with your newfound time?

The problem with keeping a strict loyalty to the Style Box system is that doing so will cause your portfolio to become redundant. Having three different types of mid-cap funds will likely contribute to a decent number of overlapped holdings (different funds buying the same stocks), and in the end, probably won't add much, if anything, to your overall portfolio's returns. You want just enough mutual funds to get adequate diversification -- get rid of everything else that is not helping you reach that goal.

KISS: Keep it simple, sweetie
Investing, like so many other things in life, often works best when we remember to simplify. The truth is, most investors would be better served with a bare-bones fund structure. How bare? To start, pick one large-value fund and one large-growth fund. This will give you exposure to growth stocks like Celgene (Nasdaq: CELG  ) and Google (Nasdaq: GOOG  ) , and also to more value-oriented stocks such as Chevron (NYSE: CVX  ) and Wells Fargo (NYSE: WFC  ) . Probably the only place you will need two funds for the same market cap mandate will be in the large-cap space, considering this is where you will likely allocate the biggest share of your investment dollars.

Next, pick either a fund that focuses on small- and mid-cap stocks (it can be growth, value, or blend), or two funds: one mid-cap, and one small-cap, in contrasting styles (small growth and mid value). Don't forget about international stocks -- pick one decent foreign fund that invests primarily in developed countries, but with a dash of emerging markets thrown in for flavor. Try to aim for a fund that is a blend, or choose the style that is complementary to your small- and mid-cap holding. Throw in a diversified bond fund if it is appropriate for you to have an allocation to fixed income securities, and you are all set.

Huh? That's it? Five to six funds? Yep, it's that simple. No real estate funds, no gold funds, no China funds, no sector funds. In the vast majority of cases, there are no solid reasons why investors need additional exposure to these types of investments. More often than not, it is simple performance-chasing that drives folks into funds like these in the first place. All you need to form the core of your investment portfolio is a half dozen good mutual funds. Diversification is the name of the game, and anything more than that is just distracting you. So, now that you know the secret to building a Foolish mutual fund portfolio, go ahead and get started on that ship-in-a-bottle hobby. And when you figure out how they actually get those ships inside the bottle, let me know.

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Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies mentioned herein. The Fool has a disclosure policy.


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