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How to diversify your mutual funds

At a glance:

  • Diversification in mutual funds: What it is and isn't

  • Ways to diversify your mutual funds

  • Summary of diversifying your mutual funds

Let’s look at what diversification is and what role it plays in building a mutual fund portfolio.

Since many mutual funds contain a broad grouping of investments, there is a certain amount of diversification in them already. But diversification comes in different flavors, as we will see.

Diversification in mutual funds: What it is and isn't

If you're having friends over for a barbecue, would you only serve meat?

Even if your guests are all diehard carnivores, they're probably sophisticated enough to expect more than just protein.

Instead, you'd probably offer an assortment—some salad, watermelon, maybe lemonade, and so on. In short, you'd diversify your table so that your guests would be satisfied.

Why you'd want to diversify your investments

Now consider investing. You want to own various types of funds so that your portfolio, as a group of investments, does well. Certain types of investments will do well at certain times while others won't.

But if you have enough variety in your portfolio, it is pretty likely you'll always have something that is performing relatively well.

Owning various types of funds can help reduce the volatility of your portfolio over the long term.

Let's say that you buy a value fund that owns a lot of cyclical stocks—stocks that tend to do well when investors are optimistic about the economy.

If that were your only fund, your returns wouldn't look very good during a recession. So you decide to diversify by finding a fund heavy in food and drug-company stocks, which tend to do relatively well during recessions.

By owning the second fund, you attempt to limit your losses in an economic downturn. That is the beauty of diversification.

mutual funds
(Getty)

What diversification isn't

Diversification isn't a magic bullet.

Having a diversified portfolio doesn't mean you'll never lose money. Diversification doesn't mean complete protection from short-term dips or market shocks.

Diversification does not guarantee that if one investment goes down, another investment will go up—it isn't a seesaw.

Here's an example of why

The year 2008 illustrated this point. The height of the financial crisis was an absolutely wretched time for investors; the average U.S. stock fund lost almost 39% that year.

The average foreign-stock fund lost 45%. Funds that bought emerging-markets stocks were down 55%.

Real estate funds tumbled almost 40%, while precious metals funds slid 30%. Even bond funds (with the exception of Treasuries) were in negative territory.

Ways to diversify your mutual funds

Diversification can occur at several different levels of your portfolio. Some of those levels are more important for mutual fund investors than others.

Diversifying across investments

Say you owned stock in a single company. If the company flourished, so would your investment. But if the company went bankrupt, you could lose all of your investment.

To reduce your dependence on that single company, you buy stock in four or five other companies, as well. Even if one of your holdings sours, your overall portfolio won't suffer as much.

By investing in a mutual fund, you're getting this same theory.

Diversifying by asset class

The three main asset classes are stocks, bonds, and cash. Some financial advisors contend that international stocks, real estate investment trusts, emerging-markets stocks, and the like are also asset classes—but the stocks/bonds/cash division is the most widely accepted.

Adding bonds and cash (cash is typically considered to be securities with maturities of one year or less) to a stock-heavy portfolio can lower your overall risk.

Adding stocks to a bond- or cash-heavy portfolio can increase your total return potential. For most investors, it is wise to own a mix of all three.

How you determine that mix depends on what your goals are and how long you plan to invest.

Diversifying by subasset classes

Within two of the three main asset classes—stocks and bonds—investors can choose several flavors of investments.

With stocks, for example, you may distinguish between U.S. stocks, foreign developed-market stocks, and emerging-markets stocks (typically considered to be stocks from emerging economies, including Latin America, the Pacific Rim, and Eastern Europe).

Furthermore, within your U.S. stock allocation, you can have large-growth, large-value, small-growth, or small-value investments.

You can also make investments in particular sectors of the market, such as real estate or technology. The possibilities for classification are endless and often overwhelming, even to experienced investors.

So what is the bottom line on diversification? Diversifying across investments and by asset class is crucial.

Subasset class diversification is useful, but not everyone needs to own a government bond fund, an international fund, a small-cap fund, a real estate fund, and on and on.

You should nonetheless consider the various ways that such investments might add diversity to your portfolio.

Summary of diversifying your mutual funds

Most investors find diversification to be necessary to their investing success, and it's easy to see why, considering the way the economy works.

There are many ways to diversify. One can diversify according to asset class, geography, industry-type, and other variables.

Luckily for us, many mutual funds have already done the work of choosing diversified investments.

That's what their management is hired to do. It is up to us as investors to research these funds and find one or two or more that fit with our investment goals and risk tolerance to craft a personal portfolio.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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