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What Is the Best Way to Weight the Stocks in Your Very Own Mutual Fund?

In this Motley Fool Answers segment, Alison Southwick, Robert Brokamp, and special guest Jim Royal get an opportunity to look at the interesting service offered by Motif.com and its custom-built mutual funds. In that process, they consider the bigger question of how to allocate your holdings and make sure your portfolio is properly diversified.

A full transcript follows the video.

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This podcast was recorded on Nov. 1, 2016.

Alison Southwick: It's time for Answers, Answers, and this week's question comes from John in Queens. Jim, feel free to chime in.

Jim Royal: Sure.

Southwick: "Alison and Bro. Love the show. Seriously, I'm that guy hitting refresh on his iTunes at 7:01 every Tuesday morning."

Robert Brokamp: Thanks, John.

Southwick: Thank you. "I've recently come across an investing platform, Motif.com, that allows you pick up to 30 individual stocks and essentially build your own custom mutual fund. My question is about how the individual stocks should be weighted. You can either weight each stock the same (in my case, each stock would be roughly 4% since I've come up with 25 stocks), or you can weight by market cap of the company, or you can customize and weight each one individually." So many options, here! Oh, my goodness!

Brokamp: I know.

Southwick: "I did a mock test of weighting by market cap, and instantly, Apple became nearly 24% of my entire portfolio, which didn't seem advisable in terms of diversification or my own goals. So, which would you choose?"

Brokamp: For those of you not familiar with Motif, it's actually an interesting little platform. You can either pick your own basket of stocks, or they have some of them preset, and you can buy the whole kit and caboodle for $9.95. That's one of the benefits of it.

First, I have a general rule of thumb that you don't have more than 5% -- maybe 10% of your portfolio -- in one single stock. Now, I'm big in diversification. A lot of people here at The Motley Fool are more comfortable having a more concentrated portfolio. Certainly, if you are investing in your company stock, then I would say definitely keep it to 5%. That, John, would lead me to say that you should definitely not do the market cap weighting where 24% of your portfolio would be in Apple.

Royal: Sure. And I have to second that, really. If you want to be passive about this, just equal weight them at that 4% figure or so. And maybe if there's something that you want a little bit more exposure to, like an Apple, move it up to 5%. Maybe 6% or something like that. But there's no reason, really, to have Apple at 24%.

Brokamp: Right. And we've talked on previous episodes about how many stocks you need to own to have a diversified portfolio. And if you look at academic studies, it's all over the place. I think in our episode, we decided 30 was a good number. I've talked with some folks recently. They said 20. So I think 25 is a good range. Of course, it has to be diversified within those 25. If all 25 stocks are tech stocks, then you're in trouble.

Royal: Right, and again, it's not 25 with one stock at 25%. It's more or less roughly equal among those to really get the benefits of diversification.

Brokamp: And as years go on, some stocks will do better. Once a company starts to become close to 10% of your portfolio, it might be time to cut it back.

Royal: Right.

Southwick: Say you're in a bunch of mutual funds. Should you worry about how much your mutual funds are concentrated? Like, between your portfolio of stocks that you personally manage and your mutual fund, do you look at all? That seems like an impossible task.

Brokamp: It's difficult to do, but it's actually an excellent point. Morningstar has a good tool for that. It's called their Portfolio X-Ray. You put in how much you own of individual stocks as well as any mutual funds that you own...

Southwick: Oh, that's cool.

Brokamp: ... and it will say, across all of your portfolio, you have 8% of your portfolio in Apple. We're picking on Apple because if you own an index fund, most of that, or at least one of the top holdings is Apple, because the typical index fund is market weighted.

Royal: Exactly. And so, similarly, Exxon might be in a variety of different funds, so you might think you're getting great diversification because you have an S&P 500 index fund or you've got a value index fund or you've got a whatever ...

Brokamp: A dividend-oriented fund ...

Royal: Dividend. Right. But Exxon is probably in every single one of those.

Brokamp: And is one of the top holdings ...

Royal: And is one of the top holdings ...

Brokamp: Probably ...

Royal: ... in each of those. So you might have 9% to 10% of your portfolio in Exxon and not really quite know that.

Brokamp: Yeah.

Southwick: Is that something to be scared about? Like, should everyone suddenly drop what they're doing? Is that a crazy example, or is that really possible?

Brokamp: No, I would say if you're like in John's situation, where you're about to put a significant amount of money in Apple (in one of these bigger companies), I think it's worth looking at how much of it is in the mutual funds that you own. If it's a small-cap stock of a lesser-known company, [or] an international stock, it's probably not going to be a big deal.

Alison Southwick has no position in any stocks mentioned. Jim Royal has no position in any stocks mentioned. Robert Brokamp, CFP has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool owns shares of ExxonMobil and has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.