Dear Dagen: How Many Funds Should You Own?

No one can tell you the exact number of kids to have.

And no one can tell you exactly the right number of funds to buy.

But a house filled with more than 12 kids will probably be unmanageable.

And a portfolio filled with more than a dozen funds -- although you don't have to worry about putting them through college -- will also be unwieldy.

The primary reason you want to own several funds is to reduce your portfolio's risk and volatility. Here's the thinking: You invest in different asset classes and sectors that won't move in the same direction at the same time. Look at the past couple of years. While large-cap stocks were going down, small-cap stocks were going up. And if you had money in both, then you did a lot better than your neighbor who still had all his money in Janus' decrepit large-growth funds.

Your basic diversified portfolio needs stocks, bonds and cash. And within those categories, you should include large-cap, small-cap and international stocks with a combination of growth and value styles. You'll also want bonds of varying credit quality and interest rate sensitivity. And there's always some room for cash.

How many funds do you need to buy to cover all of those bases? The answer entirely depends on how much work you want to do picking and tracking those investments. And the more broadly diversified the funds you're buying, the fewer you'll need.

Asset Allocation Can Go Too Far: Do you really need a fund in every sector? You could defeat the purpose of allocating.

Looking for a Little Fund Activity? Here's how to evaluate an actively managed fund.

Don't Buy Into Standard & Poor's New Alternative: Despite the intriguing idea, funds based on the new hedge fund index won't work. Here's why.

10 Questions With Pimco Tech Fund Manager Walter Price Jr.: How is he coping with the topsy-turvy market?

If you'd rather spend your spare time away from a desk, then you can build a broad portfolio by buying just one fund. That's right. Just one. Today many fund companies, notably Fidelity, Vanguard and T. Rowe Price, offer funds that own other mutual funds. With a single investment, you get an instant portfolio. (More on this below. )

If you're using broad index funds, such as a total stock market or total bond market fund, you'll need only one for each asset class. That works out to be about four. These index funds are constructed to track entire markets and so are already diversified. You can buy one large-cap index fund, one small-cap, one international and one bond index fund, and you're done.

Maybe you'd rather put your money with fund managers who are trying to beat the market rather than track it. But if you're buying these actively managed funds, you'll need more than just a handful. A fund run by an actual stock picker can be more heavily weighted to specific sectors or individual stocks -- which can mean more volatility.

A few years ago, Charles Schwab's Center for Investment Research ran computer simulations on thousands of portfolios of diversified stock and bond funds covering various asset classes. And after comparing the returns, risk and tracking errors (how much a fund's returns deviate from its benchmark index) of these portfolios, Schwab found that you should own about three diversified, actively managed stock funds per asset class and one broad bond fund. Such a break down will serve you well in any market -- especially in today's rocky one. With 10 funds you can remove a lot of risk but still have some chance of outperforming the market.

But beyond the number 10, you're overdoing it. More than 12 funds is really too many. By owning over a dozen funds, "you're so diversified that you've basically created your own index fund and paid a lot for it," says Bryan Olson, vice president of Schwab's Center for Investment Research. "There's a fine line between how much risk you want to reduce without giving up the possibility of outperforming."

Peter Di Teresa, a senior analyst at Morningstar, concurs. "After 10, you're getting into excess."

Plus, the more funds you own, the harder it is to manage and track your portfolio. You've got to juggle all that paperwork and tax reporting. And you have to monitor an actively managed fund to make sure the manager doesn't leave.

Of course, the number of funds you buy depends on what those funds own and if you've filled all the necessary gaps in your portfolio. If you've dumped all your large-cap funds and have piled all your money into 10 small-value funds, you still aren't diversified.

Here are some basic suggestions depending on how much you love buying funds.

The Simple Life

You can get by with just one mutual fund. You just need to buy a fund that owns a lot of other funds. These are called life-cycle or asset-allocation funds. A fund's allocation is typically tailored to meet a general risk tolerance or future retirement date. And the asset mix in some of these funds will change with you as you age -- getting more conservative as you get closer to retirement.

Fidelity offers six asset-allocation funds called its Freedom funds. You just have to match your retirement date to the number in the fund's name. The (FFFDX Quote)Freedom 2020 fund, for example, invests in 17 different Fidelity funds and is meant for investors who are going to retire in about 20 years.

T. Rowe Price and Vanguard also offer several low-cost funds of funds. The (PRSGX Quote)T. Rowe Price Spectrum Growth fund invests in eight other T. Rowe funds. One of Vanguard's four LifeStrategy funds will also deliver diversification with Vanguard's familiar low fees.

Efficient Market Theorist

Maybe you'd rather allocate your own assets, but don't think that the average stock picker can consistently beat the market. Then you should head straight for Vanguard, the place to go for index funds.

But it only takes a few index funds to build a solid portfolio. Vanguard's (VTSMX Quote)Total Stock Market Index fund, its (VBTLX Quote)Total Bond Market Index fund and the (VGTSX Quote)Total International Stock Index are three solid building blocks. Add a money market fund and you're done.

Fund Fan

OK, so index funds aren't that exciting. You buy them and then leave them alone. And you don't get the excitement of reading the fund manager's reports every quarter or so. If you'd rather invest in funds run by actual managers, you'll need to do a lot more research. How much experience does a manager have? Is the fund reasonably priced compared with other funds? Is the fund too big to outperform? (To find out more about how to evaluate an actively managed fund, click here.)

These are all questions you've got to answer before you buy. But there are plenty of exceptional managers out there. For value, there's Bill Nygren at Oakmark. For bonds, there's Bill Gross at Pimco. For growth, there's Tom Marsico at his own eponymous fund company.

You'll want to spread your money between different styles. For example, if your portfolio is skewed toward value funds, you'll miss the upside when growth stocks eventually make a comeback.