If you're having friends over for a barbecue, would you only serve meat? We may be a bunch of Midwesterners at Morningstar, but we're 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.
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, or 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 limit your losses in an economic downturn. That is the beauty of diversification.
Diversification: What It Isn't >>