Mutual funds are attractive investments because they offer a lot of diversification in an all-in-one package. As a managed vehicle, individual assets are bought and sold as appropriate, and market sectors are over or under weighted depending on the economic outlook—but owning a mutual fund doesn’t mean that you’re fully diversified. You’ll need at least a few to make your portfolio truly diversified against risk.
Considering that there are over 14,000 mutual funds available on the market, trying to find the perfect fund is certainly akin to searching for a needle in a haystack. You don’t need to pore over every prospectus to find something that fits your needs though. The most important aspect of investing is diversification—spreading out your assets across multiple investments so that you aren’t overly exposed to a particular risk.
Understanding What Diversification Means in a Portfolio
While a mutual fund does offer a degree of diversification, it doesn’t cover everything a proper portfolio needs. Consider what a mutual fund’s objective is—for example, let’s say a blue chip growth fund. You can expect this fund to invest primarily in large cap stocks listed on major indexes like the DJIA or S&P 500.
While the fund may invest in a number of different stocks and sectors, there’s still plenty that you’ll be missing out on. You’ll have no exposure to small or mid cap stocks, value stocks, international stocks, bonds or other assets classes.
More than One Fund
In order to create a truly diversified portfolio with mutual funds, you’ll need more than one fund to accomplish it. One mistake many investors make is confusing “balanced” funds with the relatively new Target Date funds—the latter being an investment vehicle comprised of a group of mutual funds and designed to operate as an all-in-one investment product. Balanced funds simply combine stocks and bonds in their portfolio and may not align with your particular risk tolerance.
The other thing investors tend to miss when it comes to mutual fund portfolios is the tendency for weights to shift over time. If you’re a conservative investor and hold bond and stock mutual funds, the stock funds will outperform the bond funds in the long run. That means that as your stock funds increase in value relative to your bond funds, a greater portion of your investment portfolio will be held in these riskier, more aggressive assets—something that could throw off your allocation and risk tolerance.
Diversification using mutual funds is a much simpler process than trying to do it using individual stocks; but, it still takes more than one fund to really allocate your resources correctly. Another element to mutual funds that many investors take for granted is the management team that runs the fund or the fund family itself. Just because one fund in the family is a consistent out-performer doesn’t mean that every fund available will be of equally high value. For the best results, you’ll want to branch out with other mutual fund families incorporating a variety of stock and bond mutual funds into your overall portfolio.