Mutual funds make it easy to build a strong, diversified portfolio -- which means less time chained to the computer making stock trades, and more time to do things you actually enjoy. But how many funds do you need to give your portfolio the right amount of diversity?
Think outside the box
To answer this question, most investors look to that big, overarching industry icon, the Morningstar Style Box. Morningstar's system of classifying stocks or funds uses three capitalization ranges (small, medium, or large), and three fundamental investing styles (growth, blend, or value). That yields nine possible combinations of funds, each with its own style box.
Too often, prevailing wisdom dictates that investors need to own at least one fund in each style box, to ensure exposure to 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.
It's easy to see how many investors quickly 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?
Unfortunately, strict loyalty to the style box system will likely pack your portfolio with redundant, overlapping investments. Those three different mid-cap funds you buy may end up holding many of the same stocks, which ultimately won't add much (if anything) to your investments' diversity or returns. You want to stock your portfolio with just enough funds to spread your investments across different sectors and styles.
Keep it simple
Investing, like so many other things in life, often works best when we remember to simplify. In truth, most investors would be better served with a bare-bones fund structure.
Exactly how bare depends on your personal investing tastes. But here's a sample portfolio that's about as bare-bones as they come:
- Start with one large value fund and one large growth fund. This will give you exposure to just about the entire universe of mammoth companies, from younger businesses with plenty of growth potential to more mature icons whose biggest growth periods are long past.
- Next, pick either a fund that focuses on small- and mid-cap stocks (it can be growth, value, or blend), or two different funds -- one mid-cap, and one small-cap, in contrasting styles (small growth and mid value, for example). These stocks have greater room for long-term growth than their larger peers.
- 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 a style that complements your small- and mid-cap holdings.
- Lastly, throw in a diversified bond fund if it's appropriate for you to keep a portion of your money in fixed-income investments.
That comes to five or six funds. Now, in reality, you may want to have two different funds for some types of investments -- particularly the large-cap space, where you'll likely allocate the biggest share of your investment dollars. If you want to, owning as many as a dozen or so funds shouldn't cause you problems.
Notice, though, that the model above keeps things very simple -- 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 ultra-specific types of investments. More often than not, folks pile into funds like these solely in the blind pursuit of last year's hot performance.
Now that you know the secret to building a Foolish mutual fund portfolio, go ahead and start cultivating some non-investing hobbies to take up all that time you've freed up. Underwater basket-weaving, anyone?
And once you're done planning out your leisure time, join us in our next segment to discover how to maintain a great portfolio.