One of the most important principles of investing is that you should spread your money across different types of investments to reduce risk in your portfolio. Known as diversification, some investors may achieve this by investing in a range of different funds. But how many funds do you need for your portfolio to be properly diversified?
Logic might suggest that the more funds you hold, the more diversified your portfolio becomes. In reality, you could end up with an unwieldy portfolio where you’re simply doubling up on the same investments and paying more in fund charges.
Here, we explore what to consider when you’re deciding how many funds to include in your portfolio.
What are your goals and attitude to risk?
Whether you already have a portfolio of funds or are just starting out, your financial goals and attitude to risk should be at the forefront of any investment decisions you make.
Broadly speaking, if you have a long-term goal – such as saving for retirement in a couple of decades – and are comfortable taking on investment risk, you might decide to skew your portfolio towards funds that invest in shares. For medium-term goals and a lower risk appetite, funds that invest in bonds1 may be more appropriate. Shares have typically offered higher long-term returns than bonds, but they’ve also typically carried more short-term risk.
Studies have found, time and again, that maintaining the right balance between shares and bonds – your ‘asset allocation’ – is the biggest determinant of long-term returns2. So, consider defining your asset allocation before you move on to selecting funds.
When you’re deciding whether to add (or remove) a fund, bear in mind that the ideal number for one person won’t be right for everyone. Ask yourself whether the fund will help you achieve your goals and is in line with your asset allocation and attitude to risk. And try not to make decisions based on short-term market movements. Research by Vanguard shows that even professional investment managers struggle to time the market and often get it wrong3. Making a mistake could mean missing out on your long-term goals.
What are the funds investing in?
Funds can invest in hundreds, or even thousands, of underlying investments. Some funds invest in several regions across the world, whereas others target a specific region, sector or category. Before you invest in a fund, it’s crucial to check what it’s actually investing in. That way, you’ll not only know whether it suits your goals and attitude to risk, but you’ll also avoid doubling up on the same investments.
Index funds and exchange-traded funds (ETFs)4 typically track the performance of a particular market index, such as the FTSE All-Share in the UK. If you invest in more than one UK fund or ETF, you’ll most likely duplicate your investments rather than diversify your portfolio. Even funds and ETFs with different-sounding names may overlap. For example, a lot of global funds have a large US weighting and may therefore contain a lot of the same underlying investments as a US-focused fund.
The same applies to active funds – where fund managers choose the underlying investments according to the fund’s investment objectives. If two active funds are following a similar investment objective, there could be some crossover in the underlying investments, so they might not be adding as much diversification as you think.
How many is too many?
Investing in dozens of funds not only increases the risk of duplication but could also mean you’re paying more in fees. By investing in fewer funds – or even just one fund, as we discuss below – you’re more likely to be able to control costs. Fees eat into your investment returns over time, so by keeping costs low early on, you can increase your chances of investment success.
Another drawback of investing in a lot of funds is they can be difficult to keep track of. If you’re struggling to monitor and manage your funds, you should probably ask yourself whether you’re investing in too many.
Over time, your portfolio will need rebalancing and the more funds you hold, the harder this will be. Rebalancing is when you buy and sell investments so that the balance of shares and bonds remains in line with your goals and attitude to risk. You can read more about rebalancing in this earlier article.
There’s one school of thought in the US that three funds are sufficient for a diversified portfolio. The ‘three-fund portfolio’ includes one fund/ETF investing in domestic (US) shares, another investing in international (non-US) shares and another investing in bonds. Some UK-based investors believe this translates to a two-fund portfolio for UK investors, with one fund investing in global shares and the other in bonds.
A three- or two-fund portfolio can be simple and efficient, but it won’t be right for everyone. You might prefer to invest in more funds or buy just one globally diversified fund.
Could one fund be enough?
For some investors, holding one fund could be enough. That’s because some funds are all-in-one solutions which combine different types of investments in one ready-made portfolio. Known as ‘multi-asset’ funds, some invest directly in a blend of shares and bonds. Others invest in other funds that, in turn, invest in shares and bonds.
At Vanguard, we offer two multi-asset fund ranges: our LifeStrategy funds and our Target Retirement Funds. These invest in several of our low-cost funds and/or ETFs, offering access to thousands of shares and bonds as well as different countries and industries. They’re rebalanced by our experts, so you can feel confident the fund is sticking to the right balance of shares and bonds. It’s worth noting that if an investor tried to replicate the fund and rebalance it as frequently, it would be more expensive than buying the pre-packaged solution.
If you’re not confident choosing funds, we also offer a managed service for those investing via our individual savings account (ISA) or personal pension. Our managed service will select funds based on your attitude to risk, so you don’t need to worry about the ‘ideal’ number of funds.
1 Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term.
2 See Wallick, D.W., Shanahan, J., Tasopoulos, C., and Yoon, J., 2012. “The Global Case for Strategic Asset Allocation”, Vanguard Research, and Brinson, G.P., Hood, L.R., and Beebower, G. L., 1986. “Determinants of Portfolio Performance”, Financial Analysts Journal, 42(4): 39–44.
3 Vanguard and NACUBO-TIAA Study of Endowments.
4 An ETF invests in potentially hundreds, sometimes thousands, of individual securities including shares and bonds. It trades on an exchange throughout the day like a stock and will typically track a specific market, like the FTSE 100.
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