Most investors know that they need to diversify their holdings, but that doesn’t always explain how they should achieve diversification.

Many people take the approach that “more is better” – or in other words, the more funds you own, the more diversified you are. Naturally, this isn’t the case given that a higher number simply means greater odds that two or more funds will overlap by investing in the same area of the market.

Instead, what’s important is the way that you go about diversification, and how that fits into your broader investment plan. The answer to the question “How many bond funds should you own?” therefore isn’t necessarily a specific number, but rather “Whatever it takes to meet your objectives.”

Investors typically own bond funds for a variety of reasons: income, diversification, safety of principal, or to add stability to their overall portfolio. Many investors are trying to fill a combination of these needs. In all cases, however, it’s possible to fulfill the objective with two to three funds.

Owning more than this simply creates additional paperwork, possible tax headaches, and confusion without providing any meaningful benefit. As with all things related to investing, it pays to keep things simple and streamlined.

How to Achieve Diversification

The ideal bond portfolio would provide exposure to the full spectrum of fixed-income securities – not just various types of bonds, but also the maturity spectrum (from short-term to long-term).

Although the “bond market” is often discussed as though it were a monolithic entity, that isn’t the case. For instance, the interest-rate sensitive areas of the market (Treasuries, TIPS, municipal bonds, and high-grade corporates) will respond very differently to the same set of inputs regarding economic growth and interest rates as the credit sensitive market segments (high-yield bonds, senior loans, and emerging market bonds). You can learn more about the difference between credit risk and interest rate risk here.

Along that same line, short-, intermediate- and longer-term bonds will also respond differently to economic events. For instance, concerns that the U.S. Federal Reserve will raise interest rates would have a much larger negative impact on long-term bonds than shorter-term issues, whereas a recession would likely lead to much higher returns for longer-term issues.

This helps illustrate the underlying idea behind diversification: when an event occurs in the economy (Fed decisions, economic fluctuations, geopolitical headlines, etc.), a diversified portfolio will have some investments that respond favorably to the event, and some that respond unfavorably. The net effect: not all of your investments are moving in the same direction, which means lower volatility for your portfolio.

How Many Funds Does This Require?

The short answer: probably not as many as you think. The average bond index fund invests in short-, intermediate-, and long-term bonds, and thereby averages out the exposure of these various maturity buckets. At the same time, it also provides a moderate level of interest rate sensitivity – a plus for someone who is using bonds to diversify a stock-heavy portfolio. If spreading risk away from your stock investments is all you’re looking to do, then a bond index fund may be enough.

For someone who is light in stocks and looking to achieve greater diversification within their bond portfolio, an index fund may not be enough. As discussed here, index funds only invest in a limited number of the various segments of the bond market. However, owning a fund that invests in high yield bonds or emerging market bonds along with an index fund can provide exposure to credit risk as well as interest rate risk. (Credit risk is the risk of default and a security's response to factors that would cause its default outlook to change). Keep in mind, however, that these asset classes are more volatile should be held for at least three years.

Investors can adjust their weightings between an index fund and a fund with higher credit sensitivity to gain the optimal combination of risk and return potential. Alternatively, someone who wants a lower-risk portfolio can augment an index fund with a short-term bond fund. In short, investors can achieve their objectives with a limited number of funds by fine-tuning their weightings in a strategic fashion. In contrast, there is little benefit to seeking diversification simply by increasing the number of funds in your portfolio.

What Diversification Isn’t

The way it isn’t necessarily better to have more funds can be illustrated through an example. Say an investor owns the Vanguard Total Bond Market Index Fund (BND) as a core holding. To augment this position, the investor buys an intermediate-term corporate bond fund and a long-term Treasury fund. Has the person added diversification by adding funds? In this case, no – since the Vanguard fund averages out to an intermediate maturity, is interest rate sensitive, and already owns both Treasuries and corporates, an investor who took this approach simply gets more of the same.

Is there anything wrong with owning ten or twelve bond funds? Not at all, providing you know what you own and are willing to do the work to see what each fund holds. For most investors, however, it’s easy to achieve your objectives with anywhere from one to three bond funds. Don’t confuse quantity with diversification – or you may be in for a surprise the next time the bond market experiences a downturn.