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How to Diversify a Portfolio With Less Than 5 Funds

Barbara Friedberg

The key to investing success is consistency with a diversified portfolio. But a well-diversified portfolio isn't determined by the number of funds. Sufficient diversification can be achieved in as few as one or two funds.

The reason for diversification is simple: When you invest in a wide swath of investments across various sectors, your total investment returns will be steadier, as one asset class drops, the others will shore up returns.

Although stocks historically delivered approximately 9% annualized returns, few investors are comfortable with the possibility of losing more than a third of their investment value in one year, which occurred in 2008 when the S&P 500 dropped more than 35%.

The question remains: What is the correct number of funds to own? Investors can choose one or more funds that span investment types, sectors, market capitalizations and other niches. Whether an investor chooses one or more funds, the key to a smartly diversified portfolio is to focus on a wide range of asset classes, world regions, industries, company size and style of investments.

How Many Funds are Needed for Diversification?

In the past, more than 10 funds might have been necessary for a diversified portfolio says Marko Dedovic, co-founder of Threadvest in New York. But with more than 43% of revenues coming from global sales, even the S&P 500 is globally diversified. So investors might need fewer funds than expected, Dedovic says.

The number of funds for a diversified portfolio matters less than apportioning assets to a wide variety of asset classes. You could own 10 funds, all from one sector and lack a diversified portfolio.

To create an appropriately diversified investment portfolio, start with the major asset classes. Investors need exposure to U.S. and international stocks, for the equity portion of a portfolio. This provides the potential for high returns and the opportunity to keep pace with inflation. Within the stock arena, some investors prefer to increase exposure to faster-growing small-cap stocks. While others bet on the outperformance of value or growth strategies. Beyond these basic equity asset classes, the possibilities of selecting a niche investment can incorporate sector and other strategy funds.

[See: 8 Investing Do's and Don'ts During Market Volatility.]

Bonds tend to temper the more volatile stock market returns, correlate less with the stock market returns and offer income to balance out total returns when prices fall. For the simplest bond allocation, a broad U.S. bond fund and an international bond fund suffice. Like the stock sector, other options include Treasurys, high-yield bonds, mortgage bonds and more.

Real estate and commodities are other financial assets that can be added to further diversify an investment portfolio. Finally, cash and short-term securities are helpful to stabilize returns and to fulfill short-term financial needs.

Here are a few scenarios on how to invest with fewer than five funds.

Scenario: The One-Fund Portfolio

It's possible to obtain a diversified investment portfolio by investing in one fund.

A target-date fund offers complete investment diversification within one fund. Designed with a specific retirement date in mind, these funds combine stocks and bonds in weights that become more conservative as the "target" withdrawal date nears.

[See 7 of the Best Paying Closed-End Funds.]

A 45-year-old, seeking to retire in 20 years might invest in a 2040 target-date fund like the BlackRock LIfePath Index 2040 Fund (ticker: LIKKX). Currently, the fund holds 88% stock investments and 12% bonds. The stock investments include giant- to small-cap stocks in the U.S. and abroad. While the bonds include AAA to BBB quality bonds. As 2040 approaches, the asset allocation will shift to include more bonds and fewer stocks.

Scenario: The Two-Fund Portfolio

For investors who strive for simplicity and prefer to create their own asset allocation, this diversified portfolio example includes two funds. "Investors can break down a comprehensive portfolio into two funds: global stocks and diversified bonds. This would allow them to set a strategic allocation without making explicit calls on asset classes, regions, or sectors," says Max Gokhman, head of asset allocation at Pacific Life Fund Advisors in Newport Beach, California.

For the stock allocation, the iShares MSCI World ETF ( URTH) directly tracks the MSCI World Index. Roughly 62% of the fund is investing in the United States while the top five international countries make up the next 25%: Japan, the United Kingdom, France, Canada and Germany. The nearly 1,200 securities represent all major equity sectors.

For the bond allocation, Brian Koble, chief investment officer at Hefren-Tillotson in Pittsburgh recommends the T. Rowe Price Spectrum Income Fund ( RPSIX), which invests across all major parts of the bond market from high-yield corporates to foreign bonds. The fund manager handles the asset allocation and fund management

[20 of the Best ETFs to Buy for 2019.]

Scenario: The Three-Fund Portfolio

For a handy diversified portfolio with only three funds, take a stock and bond ETF and then add a real estate fund.

The Vanguard Total World Stock ETF ( VT) encompasses world equities and a comprehensive U.S. bond fund similar to iShares Core US Aggregate Bond ETF ( AGG) takes care of bonds. Real estate is less correlated with stocks and bonds adding another layer of diversification. Since REITs are required to pay out 90% of their income in dividends, these funds offer an attractive cash flow as well. A low-fee choice is the Schwab US REIT ETF ( SCHH).

Scenario: The Four-Fund Portfolio

Core-4 offers several diversified portfolios with four funds for various types of investors and accounts.

The classic Core-4 Portfolio, created in 2007 and currently included in the Texas State Securities Board Investor Guide includes four funds: total U.S. stock market, REITs, total international stock and U.S investment-grade bond funds.

Within a four-fund portfolio, there is a variety of low-fee ETFs that could populate each of the asset classes. An all Vanguard example of the four-asset class portfolio might include Vanguard Total Stock Market ETF, Vanguard Real Estate ETF ( VNQ), Vanguard Total International Stock ETF ( VXUS), and Vanguard Total Bond Market ETF ( BND).

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