The 5 Percent Rule of Investment Allocation

By Triston Martin Updated on Sep 11, 2022
The 5% investment rule is a general investment strategy requiring investors to allocate no more than 5% of their portfolio for one investment security. This rule encourages investors to use proper diversification to maximize their potential for reasonable returns and minimize risk..

Is it too many mutual funds? It depends. Consider factors such as investment type, investor's investment goal, and investor's tolerance for risk. Remember the types of mutual fund assets and how they are structured. This will allow you to determine how much mutual fund or asset type to allocate in your portfolio. These are the essential facts to know:

Asset Class

Assets are things that can be owned or could be owned. Examples of assets include money, stocks, bonds, gold, and real property. The three main assets used to invest are cash, bonds, stocks and bonds.

Asset Allocation

Asset allocation is how investment assets are split into three types of investment: stocks, bonds, or cash. A mutual fund investor may have three mutual funds. Half of the money goes to a stock mutual fund. The other half is split equally between a bond fund and a money market fund. The portfolio would be divided equally between 50% stocks, 25% bonds and 25% cash.

Investment Securities

Securities are financial instruments that can be traded on financial markets. There are two main types of securities: debt securities and equity securities. Stocks are the most common equities. You can choose from bonds, CDs, preferred stock or more complicated instruments like collateralized securities.

Mutual Fund Categories

It is possible to classify mutual funds first according to the asset class they invest in and then further categorize them according to their strategy, purpose, or style. Investors may have a better understanding of how mutual funds are categorized by doing so, which will assist them in selecting the appropriate funds to meet their asset allocation and diversification objectives.

Sector funds

The emphasis of sector funds is on a certain industry, sector, social aims, or sectors, such as the healthcare industry, the real estate market, or the technology business. Their goal with regard to investing is to have concentrated exposure to one or more of the 10 different business sectors. Multiple industries constitute each sector of the economy. Companies that produce energy, corporations that refine oil and gas, and firms that explore new energy sources might all fall under the umbrella of the energy industry.

Investors in mutual funds sometimes purchase shares in sector funds to broaden the range of industries they are exposed. Diversified mutual funds do not specialize in a single industry and thus include holdings in all of the industry's subsectors. For example, an S&''P 500 Index Fund exposes investors to various market subsectors, including the energy, financial, technology, and utility markets.

Mutual Fund Holdings

The securities in a mutual fund's holdings are the securities. The portfolio is made up of all the underlying holdings. Imagine a bucket full of rocks. The bucket represents the mutual fund. Each rock represents a single stock/bond holding. The total number of holdings is the sum of all stocks and bonds.

How to use the 5% Rule for Investing

An investor can create a portfolio of stock securities by following the simple 5% rule. An investor could simply achieve the 5% rule by building a portfolio with 20 stocks. Many investors use mutual funds. However, this assumption is often false. Mutual funds are simple, which is one of their many advantages. However, the 5% rule can be broken if an investor doesn't know the fund's holdings.

A mutual fund investor could easily bypass the 5% rule by investing in the best S&''P 500 Index funds. The total holdings must be at least 500 stocks, and each stock must represent 1% of the fund's overall portfolio. However, some mutual funds may have high concentrations of stocks, bonds, or other assets that investors might not be aware of.

Mutual Fund Portfolios Using the 5% Rule of Investing

If the mutual fund does not violate the 5% rule, your allocation can be substantially higher than 5%. One good strategy is to use the core and satellite portfolio. This is where you choose a fund (such as an S&''P 500 Index Fund) with a high allocation percentage, such as 40% and then build around it with funds that are roughly 5% to 20%. Because they are broad-diversified, index funds can be used for the satellites and the core.

What Does The Portfolio Allocation Look Like For A Passive Investor?

The proportion of different assets in a passive investor's portfolio will change in response to market fluctuations. For instance, in 2021, an investor who does not actively manage their portfolio but invests in an S&''P 500 fund will have more than a quarter of their assets invested in the information technology industry. The second greatest allocation is in the health care sector, which accounts for around 13% of S&''P.