What is Diversification?
Before we learn how to diversify investments in mutual funds, it’s good to get acquainted with the definition and fundamentals of diversification. According to Dictionary.com, diversification is defined as: “The act of making something diverse; the state of being diverse. The process or practice of making a variety of products, investing in a variety of securities, selling a variety of goods, etc., such that failure in one or an economic downturn does not catastrophically affect the others.”
The key phrase for investors is: “… such that failure in one or an economic downturn does not catastrophically affect the others.” In other words, don’t put all your eggs in one basket. Diversify!
In simple terms, diversification means spreading risk across different types of assets, including stocks, bonds, and cash. Mutual funds make this easy.
Benefits of Diversification Using Mutual Funds
Diversification is one of many advantages of investing in mutual funds and can help investors in two ways: instant diversification and diversification of the portfolio across multiple fund categories.
First, the beauty of mutual funds is that you can invest several thousand dollars in one fund and gain instant access to a diversified portfolio. Otherwise, you might have to buy many individual securities to diversify your portfolio. This exposes you to more risk compared to what you would find in mutual funds.
For example, if you had a typical portfolio of individual stocks that includes 20 to 30 securities, this portfolio is not diversified to the extent that a mutual fund tracking the S&P 500, which includes over 500 securities, would be. In other words, a mutual fund allows the investor to diversify across many different stocks in a simpler and more cost-efficient manner.
Sometimes, when it comes to diversification, it may not be sufficient just to own many different stocks. For instance, you might own 100 stocks within a mutual fund, and all 100 of these stocks belong to the financial sector (sector fund). It is likely that whenever the financial sector goes up or down, the value of your mutual fund will rise or fall too.
This brings us to the second point. A mutual fund also allows for diversification among different styles, sectors, countries, and any possible combination of securities types you can imagine. You can either buy a general diversified mutual fund, or you can create your own diversification by purchasing a portfolio of mutual funds across different sectors.
Differentiation Is Not Always the Same as Diversification
Although mutual funds are a great tool for diversification, you may fall into a common mistake. Many investors believe that putting money into different mutual funds is enough for diversification, but differentiation is not always the same as diversification.
For example, you might invest in two different mutual funds, but it wouldn’t be beneficial if they have the same holdings. In fact, you would not be achieving actual diversification because if the securities in one fund are affected, they will also impact 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. Look at the holdings in the index you are investing in and try to spread your money across different types of mutual funds.
Risks, Rewards, and Diversification
In conclusion, a mutual fund allows for diversification across many different stocks while also permitting diversification among different sectors, styles, etc. Mutual funds can also invest in other assets like bonds, cash, or commodities such as gold and other precious metals. This diversification allows investors to reduce the risk associated with a particular stock or sector. It also opens the door to more potential opportunities by providing broader exposure to different stocks and sectors.
Overall,
Essentially, diversification allows you as an investor to achieve your primary goal, which is to increase financial wealth over time. At the same time, you reduce risks by minimizing volatility. The number of mutual funds you need for diversification largely depends on your specific investment objective.
Source: https://www.thebalancemoney.com/diversification-investing-with-mutual-funds-2466585
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