Are These the Only 2 Funds You Need?

Leonardo da Vinci was quoted as saying, "Simplicity is the ultimate sophistication." While such a generalization may not be true in all cases, it's a piece of advice that more investors should take to heart. As increasingly complex financial instruments and investments with complicated strategies are brought to the market, it can be easy to lose sight of the bigger picture. To counter that effect, one legendary investing guru is urging investors to think simple when it comes to their portfolio.

Back to basics
In a recent article for Kiplinger's Personal Finance, Greenwich Capital founder Charles Ellis recommended that investors put all of their retirement nest eggs into just two mutual funds -- Vanguard Total World Stock Fund (VTWSX) and Vanguard Total Bond Market Index (VBMFX). He feels that these two funds will offer broad diversification by nation, market, economy, and currency and should provide investors with all the basic asset class diversification they need.

Ellis also advises that investors of all ages tilt their portfolio heavily towards equities, expressing concern that retirees could run out of money if they don't supercharge their portfolio with the kind of long-term growth fuel that only stocks offer. He recommends that investors under the age of 40 allocate 100% of their money to stocks, while even someone in the 70- to 80-year old age range should aim for a 50%-50% split between stocks and bonds.

Keep it simple, stupid
So is Ellis crazy? While I think his equity allocations are a bit aggressive for older investors, he's absolutely right that even retirees still need a hefty dose of stocks for long-run growth. My concern is that many older investors can't stomach the downside that can come with a meaningful stock allocation, so a slightly more moderated equity exposure may be appropriate for some as they reach their golden years.

Moreover, while investing your whole portfolio in just two funds may seem a little bit unorthodox, Ellis has a valid point. Many investors are so eager to own newfangled offerings like leveraged exchange-traded funds or absolute return funds that they ignore solid, low-cost and well-diversified and actively-managed funds. Most investors also own more funds that they actually need, which can lead to overlap as multiple funds own the same stock, or to one manager buying as one is selling. I think he's on the right track here -- as long as you're picking good, diversified funds, owning fewer is better than more.

But I do think the two-fund portfolio is making things just a little too simple for their own good. I won't argue that Vanguard Total World Stock isn't a great choice. It's got a low 0.50% price tag and offers exposure to big-name domestic stocks like ExxonMobil (NYSE: XOM  ) and Microsoft (Nasdaq: MSFT  ) as well as foreign players like French oil company Total (NYSE: TOT  ) and British health-care concern GlaxoSmithKline (NYSE: GSK  ) .

However, one area in which this fund comes up short is in small-cap coverage -- according to Morningstar, less than 1% of assets are allocated to small-fry companies, not uncommon for a market-cap weighted fund. For long-term investors, that means they could be missing out on some of the greatest growth opportunities around!

The fund also dedicates less than 10% of fund assets to emerging markets. While that's a decent shot, more aggressive investors may want a bit more exposure to more fully to capture the gains of the fastest growing areas around the globe.

Filling the holes
To fill in some of these gaps, investors of all stripes should at the very least add a dedicated small-cap fund. If you want to stick to low-cost index funds, consider the Vanguard Small-Cap Growth Index (VISGX). This fund invests in smaller, fast-growing stocks like Palm (Nasdaq: PALM  ) , Tenet Healthcare (NYSE: THC  ) , and retailer Aeropostale (NYSE: ARO  ) , while sporting a mere 0.28% in annual costs. For another shot of emerging markets, investors could pick up Vanguard Emerging Markets Stock Index (VEIEX), which would increase their exposure to this red-hot area.

But most investors will want to move beyond this kind of ultra-simple fund portfolio, and that's fine. There are a number of solid, well-managed active mutual funds out there that would be an excellent complement to these core, indexed holdings.

Just remember Ellis's advice to keep things simple. Don't have more than one or two funds for each role in your portfolio (large growth, international developed). Stick to good, old-fashioned stock and bond funds and leave the triple-leveraged inverse funds for someone else. There's not a lot of investment advice that almost all investors across the board can apply, but the idea of keeping your portfolio simple and clean is one such gem that deserves more attention than it typically gets.