How many funds should I invest in?
How many funds should you invest in? This is a question you’d usually ask yourself at the beginning of your investment journey, but right now some longtime investors find themselves asking it too.
That’s because investors have access to a world of investment products that simply weren’t available even just a few years ago.
You can invest in funds of just about anything these days. Emerging technology funds, European value funds, gold funds, block-chain funds and multi asset funds. You name it you can invest in it.
Heck, you can even invest in funds of funds, where a fund holds shares in other investment funds rather than investing directly in stocks, bonds or other securities.
On the face of it, investing in funds makes sense when you think about it. Rather than picking individual stocks, we pick funds to diversify risk. Don’t put your eggs in one basket and all that.
Stock picking
I mean, if we were 100% confident that the stock price of Google was going to increase 30% a year for the foreseeable future, we could just stick all our savings in that one company.
Unfortunately, nobody knows what the future holds. Google may go up 30% a year. It may go up 5% a year or it may go down. However unlikely, it may even go bankrupt next year. Who knows for sure?
Some stocks go up and some stocks go down. But unfortunately, the number of stocks that go up pales in significance to the number of stocks that go down.
A study by Longboard Asset Management called The Capitalism Distribution covering the period 1983 through 2006 and the top 3,000 stocks in the US found just 25% of stocks were responsible for all the market’s gains.
39% of stocks lost money (even before inflation) during the period and 19% of stocks lost at least 75% of their value (again, before considering inflation).
In other words there’s a 25% chance of a stock going up, which leaves a very big window of opportunity for your stock to go down.
And the thing is, you may make a lot of money if you choose the right stock, but you could equally lose all your money if you get lumbered with a clanger.
The problem with fund managers?
So it’s no surprise that people often get attracted to funds run by managers that have good track records.
But even selecting a fund manager may not keep you out of trouble. That somebody did well in the past is certainly no guarantee that they will in the future.
In all likelihood sooner or later their skills or luck will run its course. It’s very difficult to be certain whether a fund manager’s success is down to skill or luck, and in the end it doesn’t matter which one it is if it runs out.
Not a year goes by without news of some high profile fund manager losing his mojo. Neil Woodford being the latest example of a superstar fund manager coming back down to earth with a bang.
It seems like only yesterday that Woodford was receiving his CBE from the Queen for services to the economy, but a quarter of a century track record of beating the market hasn’t helped his investors over the last few years as they’ve hemorrhaged their savings.
So if we can’t pick individual stocks and we can’t pick individual fund managers, what can we do?
Low cost index funds
It’s pretty simple really. You just buy as many stocks as you can. In other words, you buy low cost index funds covering as much of the market as possible.
These days you can buy global indexes that cover all the worlds major markets. Yeah, if you buy all the stocks you’ll end up with some duds.
In fact, 75% of them may be rubbish, but don’t worry because their poor performance will be more than made up by the outperformance of those 25% of stocks that do well.
Essentially, you are buying the stock market, which when you think about it is a great thing to do, because historically the stock market as a whole has generously rewarded investors over time.
In fact, investing in the market as a whole provides investors with better returns than most everybody else. That’s because everybody who doesn’t go with the market has to fit in one of two groups.
One group, ‘the winners’ that’s done better than the market and one group, ‘the losers’ that’s done worse than the market. So right off the bat you’ve done better than the losers by just going with the market.
And though on paper the winners should have beaten you and the market, high fees mean they won’t have done.
That’s because what stacks the odds firmly in your favor is the fact that most of those guys who aren’t going with the market are investing through funds, run by managers, and managers don’t work for free.
Once you’ve taken fees into consideration going with the market is going to provide better returns than most other methods achieve. Just think about it. If your fund is one of the lucky ones that’s beaten the market by say 1.5%, but you pay 2% in fees, the end result is that you’ll have underperformed the market by 0.5%.
Going with the market
Going with the market through passively managed low cost index funds is the most tax efficient and cheapest option available. And the best bit, is that you don’t have to do anything!
In essence investing seems to work in almost the opposite way to much anything else. Usually, more work and higher fees means better results, but not with investing. The more you pay in fees, the less you keep for yourself and the more work you do, the more chance you have of making mistakes.
Passively going with the market also has psychological advantages. It is easier to stick to your investment plan. When you are down, so is just about everyone else. When you are all in it together you don’t feel so bad.
But, if you don’t go with the market, you could be down for years on end while everybody else is making money. Think how bad you’d feel then.
Just ask those guys who invested in Neil Woodford’s investment funds. Just about every one of them would have underperformed the market over the last 5 years, in funds run by one of the most successful and famous fund managers the UK has ever had.
The bottom line is all other approaches are more risky. They may work. They may not. But if you invest in the wider global market you’ll have all your bases covered.
When people are talking about US stocks outperforming as they have in recent years, you’ll be happy in the knowledge you have them in your portfolio.
When people are talking about investing in real estate companies, you won’t have to change anything because you’ll have them in your portfolio.
You don’t even have to worry about commodities like gold and oil. Lot’s of companies that deal with this stuff will be in your portfolio. You name it. It’s going to be in there!
The question at hand
Which brings us back to the question at hand. What number of funds is optimal?
And the answer is…… It depends!
And that’s because for most investors it’s going to come down to a trade off between diversification, costs simplicity, risk and availability.
Diversification
As you diversify across more companies, industrial sectors and geographies, your returns more closely follow that of the overall market, which is a good thing because the market has been generous throughout its history.
As a bonus, the likelihood that your portfolio runs into serious problems over the long term also diminishes.
Costs
The less you pay, the more you keep for yourself. Fees can add up and seriously detract from your investment returns. People hear 1 or 2% and don’t think it sounds much, but think about it this way.
Historically global stocks have provided about 4-5% over inflation. Let’s call it 4%. If your fees are 2% you are only left with 2%. You’ve effectively given away half your returns! That ain’t a good way to make money in anybody’s book!
Simplicity
The lower the number of funds you have the simpler your investments become. If you have 10 funds you’ve got more things to think about, especially if you plan to add money at regular intervals.
In that case, you’ll have to mess around buying different amounts of each of them every month.
Most investment strategies work by having an asset allocation that you stick to and which involves rebalancing. In other words, you’d have a fixed amount as a percentage of each fund.
When things get out of wack, you need to adjust your portfolio back to equilibrium, which may not be easy if you need more than one hand to count your funds.
Risk
How much risk you are willing to take on may also influence how many funds you have in your portfolio. To reduce risk many investors will have some bonds in their portfolio, which in turn could lead to having an extra fund to deal with.
Bonds don’t tend to go up as much as stocks, but they don’t tend to go down as much as stocks either. In fact, developed market government bonds tend to increase in value when stocks crash i.e. with bonds you won’t lose as much money when the crash comes!
(Risk is a big topic that you need to think about very carefully. You can read more about it here.)
Availability
I’m sure it goes without saying that, you can only invest in products that are available to you. Take British expats for example, we are usually restricted from investing in common UK products like Open Ended Investment Companies and Unit Trusts, and often can’t open accounts on many UK investment platforms.
However, in a world of online brokers and exchange traded funds the problem isn’t insurmountable, but it does mean the very best options might not be available to everyone.
Vanguard Life Strategy
As an example, based on all the trade offs you can make I think Vanguard Life Strategy Exchange Traded Funds (ETFs) are going to be a fantastic option for a lot of investors.
These are low-cost, one-stop-shop portfolios that provide broad exposure across geographies and asset classes. In other words with Vanguard Life Strategy you only need one fund. (You can read more about them here.)
There are other one fund alternatives, but they tend to have some issue associated with them, particularly where British Expats are concerned. Usually, they come in other fund formats which we simply don’t have access to, but fees or being actively managed are other common issues.
Take MyMap, from the other big player in the industry, Blackrock for example. MyMap funds aren’t usually available to expats, and even if they were you’d have to be comfortable with an active management strategy, which Blackrock use on these funds.
If the UK’s most successful fund manager doesn’t seem to be able to beat the market, what suggests a couple of people at Blackrock we’ve never heard of are going to do any better?
That’s not to say it’s impossible that they will beat the market and even if they don’t, low fees means equaling the market would be just fine, but if there’s a risk they’ll underperform why bother when the market returns are there for the taking?
These days, there are tonnes of global stock funds you can choose form. I need to go back to Vanguard for a good example. (What can I say? It’s no wonder Vanguard are so popular.)
The Vanguard All World UCITS ETF is a great choice. It covers 90-95% of the investable stock market capitalization of global stock markets through exposure to 49 countries and has ongoing charges of 0.25%.
All you have to do is pair something like this with a suitable bond fund, pick a split between the two and hey presto! Which bond fund you choose may take a little more thinking about.
In many cases, a short term developed market government bond fund or an inflation linked bond fund of the country where you live will serve you well, but not in every case.
(I’ve listed some ETFs suitable for British expat investing here and you can read more about bonds here.)
The bottom line
In the end how many funds you should invest in usually comes down to to a trade off between diversification, costs simplicity, risk and availability.
For investors who have access to them one fund should be enough providing it is a well diversified, multi asset low cost option.
Investors without access, or where the only access they do have, would mean costs being prohibitive should be able to achieve the same goal using two funds.
In other words one or two funds should be enough for most investors.
