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The decision to invest to build long-term wealth is complicated by the plethora of choices. With thousands of funds available to U.S. investors, how many funds should you own to save for retirement?
“Ideally, you should be able to count your mutual funds with the fingers on your hands,” says James H. Lee, a certified financial planner and founder of Delaware-based investment advisory firm StratFI.
We asked financial advisors to answer some common questions about selecting funds — such as mutual funds, index funds and exchange-traded funds — to build a retirement portfolio.
Why are funds preferred for retirement savings?
While it’s possible to build a diversified portfolio purchasing individual company stocks or bonds, most investors don’t have the time, experience or cash to build a broad portfolio on their own. Purchasing shares in funds can be a cost-effective way to invest with instant diversification.
“If you build your own portfolio, you could be overweighted in certain industries, certain themes, certain investing styles,” Lee says. “Mutual funds are a great way to easily diversify and spread risk around.”
“The first thing to note is that when [financial advisors] say ‘funds,’ there are usually two kinds we’re referring to: mutual funds and exchange-traded funds,” says Scott Schleicher, senior financial advisor at Personal Capital, an online financial planning company.
These funds come in many varieties, but in general mutual funds can be actively managed — attempting to beat average market returns — or follow an index such as the S&P 500, in which case the fund will rise and fall in value as the index does. Funds that track an index are known as index funds. A close cousin of index funds are ETFs.
“ETFs mostly follow an index, are usually cheaper, more tax-efficient, and as the name implies, can be traded throughout the day like a stock on an exchange,” Schleicher says.
Should I put all my money in one mutual fund?
That depends on the fund.
“Sometimes it is enough to have just one fund. Balanced funds and target-date funds are fully diversified and are built to manage risk,” Lee says. “Alternatively, you might have just one fund if you are just starting out.”
Target-date funds are a type of mutual fund designed to be a “one and done” option geared toward retirement savings. These funds — also known as life-cycle or target-retirement funds — make automatic portfolio adjustments to grow more conservative the closer you are to retirement age.
If you contribute to a 401(k) retirement plan through your employer, there’s a good chance you may be investing in this type of fund. A 2020 report from investment company Vanguard shows that 78% of participants in retirement plans it manages contribute to a target-date fund, and 54% solely use target-date funds for investment.
How many funds make an ideal portfolio? Can I buy too many?
The question is less about the number of funds you should use to invest for retirement and more about the range of funds you need to be adequately diversified.
For example, robo-advisors — online investment firms that create automated portfolios for investors — typically use at least eight to 10 ETFs to diversify each client’s account, an analysis by NerdWallet shows.
Each ETF contributes to the total portfolio by focusing on a specific asset class. Common fund asset classes include U.S. stocks by size of company (such as large, midsize and small public companies), stocks of international companies in developed or developing countries, and bond funds that hold U.S. Treasurys, corporate debt or municipal bonds.
What’s key is to know what’s under the hood of your existing funds and how new fund purchases might increase your exposure to new asset classes. “For example, you could hold three ETFs that all partially consist of large-cap U.S. tech stock holdings, potentially leading to overexposure in that area,” Schleicher says.
“Just watch out of overlap between your funds,” Lee says. “If you are not careful, you may be less diversified than you think.”
— By Kevin Voigt.