Well when it comes to diversifying your portfolio, it is extremely difficult to accurately answer the question of how many index funds should I own. Well, to start off index funds are diversified investment vehicles. So this means that when you invest in an index fund, your capital will be highly diversified across multiple stocks. With that in mind, there is no right answer to this question. There are however some important points to consider that might help you make this decision.
Index funds are already diversified
If you invest in stocks it is understandable that you might want to diversify and hold a portfolio of different stocks. However, if you invest in index funds you are already very well diversified. An index fund holds several stocks, and this ensures that your portfolio is already diversified. As an investor, you may wish to be even more diversified by investing in several index funds. This option might be the right investment decision for some investors, but a few points must be considered.
What are you trying to diversify?
Most index funds hold companies in different sectors and industries. This ensures that when it comes to a certain economic activity, your investment is pretty well-diversified. The only reason you would want to further diversify is if you are looking to invest in different regions of the world.
Let’s imagine for a second that you have invested in an S&P 500 index fund, perhaps you would like to get some exposure to other countries outside of the US. So If you are trying to increase your regional diversification then it might be a good option to consider an overseas index fund. This will guarantee you exposure to other markets and further diversify your portfolio.
Fees and how many index funds should I own?
Well one of the disadvantages of owning several index funds, is that you may be subject to different fees charged depending on the funds you choose to invest. This is something that needs to be considered when you are deciding how to build your index fund portfolio.
Calculate how many index funds you wish to own, and how many fees you would be subjected to. This allows you to roughly estimate how many fees you will incur over the course of a year. You can also select how many index funds you should own, based on the fees. It is important to make sure that you are not being overcharged in fees by one fund, relative to the other. As this will increase your annual fees expense.
Diversification that is diworsification
Perhaps the most important thing to consider is that index funds are already very well-diversified, and if you choose to diversify your index fund portfolio too much you might be over diversifying. This might lead to diworsification, meaning that you are just diversifying for the sake of it. Diluting your portfolio into tinier and tinier positions will ultimately leave you with very little upside, in case one of the rises in price significantly.
Consider your investment profile and risk profile
Broadly speaking index funds are designed to be less volatile and risky, than individual stocks. However, in some cases, index funds are inefficient. It all comes down to your investor profile. risk tolerance, and risk capacity. Both of them will help you define your investor profile. It should be used extensively as the backbone of your investment strategy.
If for instance you are retired and pretend to still have a certain exposure to equities, it might be a good solution to diversify across several funds. If on the other hand, you are a relatively young investor looking to take additional risks, in order to achieve higher returns, this strategy might not be the best solution for you.
So, how many index funds should I own?
Well as you see there is no right answer as to how many index funds you should own. It is a very broad question that is highly dependent on your investment profile. Therefore consider the important points mentioned, so that you can decide what works best for you.
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