Diversification: Investing With Mutual Funds

Diversification Advantages and Investing With Mutual Funds

Diversification - eggs in different baskets
Diversification with mutual funds:Don't put all your eggs in one basket!. Getty Images

Diversification is one of the most important aspects of investing. But what exactly is diversification and how does one go about diversifying with mutual funds?

If the three most important things about investing in real estate are location, location and location, then the three most important things about investing in capital markets are diversification, diversification and diversification.

Fortunately investing with mutual funds makes the job of diversification much easier for investors than investing in individual securities like stocks and bonds.

What Is Diversification?

Before learning how to diversify with mutual funds, it's a good idea to learn the definition and basics of diversification.

According to Dictionary.com, diversification is defined as:

  1. the act or process of diversifying; state of being diversified.
  2. the act or practice of manufacturing a variety of products, investing in a variety of securities, selling a variety of merchandise, etc., so that a failure in or an economic slump affecting one of them will not be disastrous.

The key phrase about diversification listed above is: "…so that a failure in or an economic slump affecting one of them will not be disastrous." In other words, don’t put all of your eggs in one basket. Diversify!

Put simply, diversification is spreading risk across different asset types, which include stocks, bonds and cash. Mutual funds make it easy to do this.

Diversification Advantages With Mutual Funds

Diversification is one of the many advantages of investing in mutual funds.

When it comes to diversification, mutual funds can help an investor in two ways.

First, the beauty of mutual funds is that you can invest a few thousand dollars in one fund and obtain instant access to a diversified portfolio. Otherwise, in order to diversify your portfolio, you might have to buy many individual securities, which can still expose you to more risk relative to mutual funds.

For example, if you have a typical portfolio of individual stocks, which might include 20 to 30 securities, this portfolio is not near as diversified as one mutual fund that tracks the S&P 500, which includes more than 500 securities. In other words, a mutual fund allows an investor to diversify into many different stocks for in a more simple and cost-effective way.

Sometimes, when it comes to diversification, it’s not good enough to simply own many different stocks. For example, if you own 100 stocks within a mutual fund, and those 100 stocks are in the financial sector (a sector mutual fund), more than likely as the financial sector moves up and down, so does the value of your mutual fund.

That brings us to the second point. A mutual fund also allows for diversification between various styles, sectors, countries, and, well, just about any combination of security types you can imagine. You can either buy a mutual fund that is broadly diversified, or you can buy a portfolio of mutual funds across various sectors -- creating your own diversification.

Risk, Reward and Diversification With Mutual Funds

In summary, a mutual fund allows for diversification between many different stocks and also allows for diversification between various sectors, styles, etc.

Mutual funds can also invest in other assets, such as bonds, cash, or commodities, such as gold and other precious metals. This diversification allows investors to reduce the risk of one particular stock or sector, but also allows for more potential reward by offering a broader exposure to various stocks and sectors.

Essentially, diversification allows an investor to accomplish their primary task, which is to grow financial wealth over time, AND they are enabled to minimize risk at the same time by reducing volatility.

Also See: Best Amount of Mutual Funds to Be Diversified

Updated June 27, 2017 by Kent Thune