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Course 301
Why Diversify?

Introduction

In this lesson, we'll cover what diversification is and what role it plays in building a mutual fund portfolio. Subsequent lessons in this level will discuss how to build a portfolio of mutual funds.

Diversification: What It Is

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

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.

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. The lesson: Because all sorts of investments can suffer at the same time, your only sure-fire protection against sudden losses is to put some of your assets in a money market fund.

Ways to Diversify

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.

Quiz 301
There is only one correct answer to each question.

1 Which statement is false?
a. Diversification can improve your return over the short term.
b. Diversification can lower your volatility over the long term.
c. Diversification can ensure that you never lose money.
2 If you want more certain protection against short-term losses, buy:
a. A money market fund.
b. A real estate fund.
c. A large-cap fund.
3 Which is the least important type of diversification?
a. By investment.
b. By asset class.
c. By subasset class.
4 What does diversifying by asset class usually mean?
a. Owning multiple U.S. companies.
b. Owning a mix of stocks, bonds, and cash.
c. Owning a mix of growth, value, and international stocks.
5 You should own:
a. A small-company fund.
b. A bond fund.
c. Maybe neither.
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