How to Get a Perfectly Diversified Portfolio with Two Funds


On the surface, a two-fund portfolio might seem light on diversification. But consider that each fund owns thousands of distinct stocks or bonds. It’s clear that excellent diversification is possible with a two-fund portfolio. And that is especially true if you pick two of the best funds for that portfolio.

A stock market ticker tape that reads "ETFs." representing best etfs

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In fact, M1 Finance, the digital investment management platform, has nine pre-made portfolios consisting of just two funds.

The difference between each of these two-fund portfolios is simply the amount allocated to each fund. The most conservative choice allocates 10% to equities and 90% to fixed assets. At the same time, the most aggressive choice is reversed and deploys 90% to equities and 10% to bonds.

Why Diversify?

The goal of diversification is simple. Invest in assets that do not move in the same direction at the same time. So when the tech industry swoons, you’ll have utilities to prop up your returns. And when stocks tank, your bonds will temper the losses.

In fact, in recent years, more broadly diversified portfolios may have performed worse than the simple diversified stock and bond portfolios. Value stocks have underperformed, so a portfolio leaning toward that investing style would have suffered.

Recent investment performance simply underscores several important realities. The future of investment returns is unpredictable. No one knows for certain which asset classes will outperform next year, or over the next decade. Picking a portfolio of last decade’s outperformers doesn’t guarantee that prior returns will continue.

So choosing a two-fund portfolio may or may not outperform a more diversified asset mix, but there’s no way to know which corners of the market will soar next.

Best Funds for a Two-Fund Portfolio

In my prior example, the two-fund portfolio invests in two low-fee funds: Vanguard Total Bond Market (NASDAQ:BND) and Vanguard Total World Stock Index Fund (NYSEARCA:VT).

The Vanguard Total World Stock fund deploys nearly 60% to North American firms with 11% in emerging markets and the remaining 30% of its assets in global developed market firms.

Vanguard’s diversified U.S. bond fund concentrates its holdings in the intermediate term U.S. investment-grade bonds.

There are scores of comparable funds that can replicate a wide swath of the global and U.S. stock and bond markets.

The iShares MSCI World ETF (NYSEARCA:URTH), owns roughly 1,225 companies and allocates 65% of its holdings to U.S. companies and the remainder to global equities.

The iShares MSCI ACWI ETF (NASDAQ:ACWI) owns roughly 2,300 large- and mid-cap equities in developed markets along with emerging markets. Along with broad diversification, investors also enjoy a recent 1.7% yield.

The bond portion of the two-fund portfolio also offers an array of options.

The iShares Core US Aggregate Bond ETF (NYSEARCA:AGG) is one of the most popular diversified bond funds. AGG owns 8,244 distinct bonds and includes 69% AAA rated bonds.

Those interested in higher global bond yields might consider the Vanguard Total International Bond ETF (NASDAQ:BNDX). Investors should note that BNDX only allocates 3.4% to the U.S. bond market.

When choosing the specific funds, there are several factors to consider. Typically there’s an inverse relationship between expenses and returns. This means investors consider index funds with lower expense ratios. Personal preference may come into play when allocating percentages of U.S. versus global assets.

After choosing the two best funds for your needs, consider your preferred asset allocation.

Two-Fund Portfolio Asset Allocation

Asset allocation percentages are known to be major contributors to investment returns.

Historically, greater percentages invested in riskier equities has led to higher overall returns. Although, there are periods when this is not the case.

During the decade following the bursting of the tech bubble, from 2000 through 2010, stocks returned less than their long-term historical averages. Bonds surpassed their prior average returns.

During the first decade of the new millennium, the S&P 500 lost 0.95% annually while the Barclays U.S. Aggregate Bond index garnered 6.33% per year on average. In contrast, during the 1980s the S&P 500 averaged 17.55% annually and the Barclays U.S. Aggregate Bond index averaged 12.43% annually.

Yet, over the last 92 years or so, the U.S. stock market returns, as represented by the S&P 500, have been roughly 9% per year. Since 1928, the 10-year U.S. Treasury has returned 5% each year on average.

After digesting historical best- and worst-case scenarios, investors are armed with sufficient data to elect an appropriate asset allocation.

Choose an asset allocation that fits with your age, risk tolerance and financial goals. Younger and more aggressive investors lean toward a greater equity allocation while the conservative crowd will favor a heavier bond weighting.

The Bottom Line

A sufficiently diversified two-fund portfolio is possible. In fact, it is even desirable.

The benefits of a simple two-fund investment portfolio suggest minimal account management responsibilities and the likelihood of market-matching returns. With data substantiating that passively managed index funds beat active investment managers 70% of the time, this strategy has a lot to recommend.

Barbara A. Friedberg, MBA, MS is a veteran portfolio manager, expert investor, and former university finance instructor. She is editor/author of Personal Finance: An Encyclopedia of Modern Money Management and two additional money books. She is CEO of Robo-Advisor, a robo-advisor review and information website. Additionally, Friedberg is publisher of the well-regarded investment website Barbara Friedberg Personal Follow her on twitter @barbfriedberg and @roboadvisorpros. As of this writing, she held an account with M1 Finance.

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