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 protection.
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 (typically considered to be securities with maturities of one year or less) to a stock-heavy portfolio lowers your overall risk. Adding stocks to a bond- or cash-heavy portfolio increases 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-and allow you to rest a little easier.