How many mutual funds is optimal for your portfolio?

How many mutual funds are enough both for profitableness and safety requirements? The common consensus is that a well-balanced portfolio with approximately 20 to 30 stocks diversifies away the maximum amount of unsystematic risk. Because a single mutual fund often contains five times that number of stocks, does that mean that one fund is enough? Some people would say, "Yes." Here we'll show you both sides of the debate and help you determine how many mutual funds is optimal for your portfolio.

Proponents of the "Yes" theory suggest that equity investors buy a broad index fund, such as the Vanguard Total Stock Market Fund, and let time do its work. Even investors seeking exposure to both stocks and bonds can get their desired asset allocation through the purchase of a single balanced fund.

Others would say "No, you definitely need more than one fund." On the equity side, they would note that a single fund would fail to provide adequate exposure to international investments. The argument here is that a global fund provides a little bit of everything, but not enough of anything. From there, the argument goes that a large-cap domestic fund and a small-cap domestic fund cover the bases on the home front. An international fund, perhaps two at most, cover the international front. Two-fund proponents select one fund from the developed foreign markets, like Europe, and the second in emerging markets such as the Pacific Rim or Latin America. If fixed-income exposure is desired, a domestic bond fund is added to the mix, bringing the count to six funds.

What about the style box?
The traditional mutual-fund style box consists of nine investment categories representing domestic equities. Those categories are based on market capitalization (micro, small, mid, large, etc.) and investment style (value, mixed, growth). The bond style box, in similar fashion, has three maturity categories (short-term, intermediate and long-term) and three categories of credit quality (high, medium, and low). An investor does not need a fund in all the stock and bond categories. A few funds can be chosen that best fit an investor's asset-allocation and risk-return requirements.

The Downside of Diversification
While mutual funds are popular and attractive investments because they provide exposure to a number of stocks in a single investment vehicle, too much of a good thing can be a bad idea.

The addition of an increasing number of funds simply creates an expensive index fund. This notion is based on the fact that having too many funds negates the impact that any single fund can have on performance, while the expense ratios of multiple funds generally add up to a number that is greater than average. The end result is that expense ratios rise while performance is often mediocre.

No Magic Number
Although there are hundreds of mutual fund providers offering thousands of funds, there's no magic number for the "right" number of mutual funds in a portfolio. Despite the lack of agreement among the professionals regarding how many funds are enough, nearly everyone agrees that there is no need for dozens of holdings. In fact, even many mutual fund companies are now promoting life-cycle funds, which consist of a mutual fund that invests in multiple underlying funds The concept is simple: pick one life-cycle fund, put all of your money into it, and forget about it until your reach retirement age. These funds, also referred to as "age-based funds" or "target-date funds," have an intrinsic appeal that's hard to beat.

Building Your Own Portfolio
If you prefer to build a portfolio rather than buy an all-in-one solution, there are simple steps you can take to limit the number of funds in your portfolio while still feeling comfortable with your holdings. It begins by considering your objectives. If income is your primary goal, that international fund may not be necessary. If capital preservation is your objective, a small-cap fund may not be needed either.

Once you've determined the mix of funds that you wish to consider, compare their underlying holdings. If two or more funds have significant overlap in holdings, some of those funds can be eliminated. There's simply no point in having multiple funds that hold the same underlying stocks.

Next, look at the expense ratios. When two funds have similar holdings, go with the less expensive choice and eliminate the other fund. Every penny saved on fees is one more penny working for you. If you are working with an existing portfolio rather than building one from scratch, eliminate funds that have balances that are too small to make an impact on overall portfolio performance. If you've got three large-cap funds, move the money to a single fund. The amount spent on management-related expenses is likely to decrease and your level of diversification will remain the same.