Diversification with mutual funds is more than just putting your eggs into different baskets. Many investors make the mistake of thinking that spreading money among several mutual funds means they have an adequately diversified portfolio. However, different does not mean diverse.
In my advisory practice, I see new clients come to me with a portfolio of several funds but many of them have similar objectives. For example, any random Large-cap stock fund and an S&P 500 Index fund will typically have similar holdings. In fact, their holdings could be so similar that the performance is almost identical.
Why Diversify?
The point of diversification is not that the funds have different names or come from different fund families but that the funds each represent different types of fund categories. You want the objectives and performance of the funds to have low correlation with each other. In different words, you want one fund to "zig" while the other "zags." If most or all of your funds perform similarly, you may as well just have one fund, which is not diversification.
Example of Diversification
A simple example of good diversification (low correlation) can be found by comparing and contrasting a stock mutual fund with a bond fund. Often, stocks perform well in environments where bonds may not do so well, and vice-verse. The low correlation reduces the volatility (ups and downs)of the overall portfolio and provides the investor with a smoother ride and hopefully an acceptable average return. Also, over long periods of time, stocks tend to outperform bonds. Therefore, a moderate portfolio of two-thirds stocks and one-third bonds, for example, may be suitable for an investor who wants to outpace inflation but keep volatility to a moderate level.
In summary, diversification serves a dual purpose: It reduces market risk by smoothing out the rough edges of volatility but this quality also makes for a more comfortable ride--one which the investor may be more willing to stay with through the roughest of economic and market conditions. The investor reduces market risk but also reduces the risk of abandoning the investment objective, which is among the worst mistakes an investor can make.
Advanced Tip
For advanced investors, or for new investors wanting to learn more about diversification with mutual funds, a mutual fund's statistical measure of correlation to a given benchmark can be found by looking at the fund's beta and R-squared, which are both available through Morningstar.
Disclaimer:
The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
