Diversification of Mutual Funds

Diversification involves spreading your money around among several different kinds of investments in order to reduce the risk of concentrating in a single security. When your investments are diversified, you don’t take a major hit if any one investment performs poorly. Thus, the savvy investor avoids concentrating all her investments in the stock of a single company, or even a single industry. You may be lucky enough to work for a company that helps you invest through a 401(k) retirement plan or by awarding you stock options — the opportunity to buy the company’s stock at a special, often discounted, price. Either way, you enjoy a great reward for being an employee. But be careful — employees sometimes end up investing almost their entire savings in the stock of the company they work for. All is well as long as the company is flourishing. But if the industry suffers a downturn, or if your own company happens to go bankrupt, you may find that your investment is suddenly worth little or nothing.

Mutual funds also allow you to diversify your investments at a relatively low cost. Because of transaction costs (the fees charged when you buy or sell stock), you can waste time and Volatile investment Volatile investment money buying one or two shares of stock in a dozen different companies, which may be all that an investor with a couple of thousand dollars can afford. But the same investor can easily afford to invest in one or more mutual funds. Buying mutual fund shares makes you a part owner of many different types of stocks (or bonds), giving you the benefits of diversification at a fraction of the cost. By definition, any mutual fund offers some degree of diversification, because every fund invests in many different stocks or bonds. But some funds are more diversified than others. For example, sector funds, which concentrate on investing in a single industry, are less diversified than most other stock funds. When economic trends favor that industry, the corresponding sector fund profits.

For example, during the late 1990s, sector funds that concentrate on the stock of Internet companies and other hi-tech businesses have done very well. If and when high-tech industry flounders, however, the technology funds will, too. Thus, keeping all your money is one such fund would be a risky strategy.