How many mutual funds should you own? Find out

Morningstar conducted a study to find out the number of funds you should own in your portfolio. Here are some interesting findings.

Mutual funds are a good way to invest money in stocks or bonds where a professional manager strives to get better returns than the overall respective market.

But mutual-fund investors often grapple with the question: what should be an ideal number of funds that one should own in a portfolio?

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Like with stocks, owning a small number of mutual funds could add to the volatility of your investments as you expose your portfolio to the swings and fortunes of the funds you own.

How many mutual funds do you then need to have a diverse enough portfolio?

To find out if more funds mute volatility the same way more stocks do, Morningstar created hypothetical portfolios ranging from one to 30 funds, using every possible permutation of funds.

We then calculated five-year standard deviations for each of those portfolios.

What is standard deviation?

Standard deviation is a measure of volatility an investment has undergone in the past. A higher standard deviation can spell bigger gains or losses, while a lower number indicates a less volatile portfolio.

Morningstar found that single-fund portfolios had the highest standard deviation, delivering either the biggest gains or the heaviest losses.

So owning just one fund can be a risky bet.

Add a fund and the standard deviation drops significantly. Returns are lower, but the downside is less severe, too.

After seven funds, however, a portfolio's standard deviation stays pretty much the same regardless of how many funds you add.

In other words, once you own seven funds, there may be no need for more.

What you really need: diversification

But the number of securities you own is less important than how diverse those securities are.

Seven large-cap funds likely won't diversify your portfolio the same way owning one large-cap fund and one small-cap fund would.

You can use tools such as online portfolio managers available on Morningstar or similar web sites where you can analyse your portfolio and look up its diversification across asset classes, and with respect to sectors and market capitalisation for stocks.

You're looking for two things: Funds that invest in the same way, and holes in your portfolio. More than one large-cap fund, for example, won't add much to your portfolio.

The odds are pretty good that if you own multiple investments doing the same thing, one is better than the others. Focus your money on the best choices.

Don't forget that you can have overlap even though you own just a small number of securities. Conversely, even if you own a lot of investments you could still have gaps in your portfolio.

The bottom line: Don't obsess over the number of securities/mutual funds that you own. Instead, concentrate on their diversity.