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?
We can compare mutual funds to the three most important things about investing in real estate: location, location, and location. Therefore, the three critical aspects of investing in capital markets are diversification, diversification, and diversification.
Fortunately for investors, investing in mutual funds makes the job of diversification much easier than investing in individual securities like stocks and bonds. The funds already have diverse holdings, but there are some common traps you can fall into without realizing it.
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:
- the act or process of diversifying; the state of being diversified.
- 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 for investors 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 types of assets, including 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 and it can help an investor in two ways: instant diversification and portfolio diversification in multiple fund categories.
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. This can expose you to more risk than you would find in mutual funds.
For example, if you have a typical portfolio of individual stocks that includes 20 to 30 securities, this portfolio is not nearly as diversified as one mutual fund that tracks the S&P 500, which includes over 500 securities. In other words, a mutual fund allows an investor to diversify into many different stocks in a simpler and more cost-effective way.
Sometimes, when it comes to diversification, it’s not good enough to simply own many different stocks. For example, you might own 100 stocks within a mutual fund, and those 100 stocks are in the financial sector (a sector mutual fund). It is more than likely that 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 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 and create your own diversification.
Different Is Not Always the Same as Diverse
While mutual funds are a great tool for diversification, you might also be caught up in a common mistake. Many investors think that putting money into different mutual funds is enough diversification, but different is not always the same thing as diverse.
For instance, you may invest in two different mutual funds, but it does no good if they both have the same holdings. You are not actually diversifying because if something affects the securities in one fund, it will also affect the other fund.
To truly diversify your portfolio, you need to invest in a mutual fund that does not share holdings with your other funds. Consider which holdings the index you're investing have and try to spread your money throughout different types of mutual fund categories.
Risk, Reward, and Diversification
In summary, a mutual fund allows for diversification between many different stocks while also allowing for diversification between various sectors, styles, etc. Mutual funds can also invest in other assets, such as bonds, cash, or commodities like gold and other precious metals. This diversification allows investors to reduce the risk of one particular stock or sector. It also opens you up for more potential rewards by offering a broader exposure to various stocks and sectors.
Essentially, diversification allows you as an investor to accomplish your primary task, which is to grow financial wealth over time. At the same time, you are minimizing risk by reducing volatility. Just how many mutual funds you need for diversification depends largely on your investment objective.