Diversification in Mutual Funds
Diversification in investing means acquiring securities with assets that are unrelated to one another.
For instance, a diversified stock portfolio might include technology, food service, and petroleum industry stocks. The products and markets of these companies are unrelated enough that no one economic factor—like a drop in oil prices, for instance—will have a dramatic effect on the performance of the entire portfolio. It is not easy to design a diversified portfolio. First, there is the time-consuming task of weighing and balancing the risks of each investment you include in your portfolio. You also need sufficient capital to purchase the broad scope of investments needed in sufficient quantities to take advantage of low transaction costs.
A Built-in Feature
Diversification is built in to mutual funds. Mutual funds collect money from many investors, pool it, and then buy different securities. These investments may include stocks, bonds, money market instruments, and derivatives. How much of each type of investment a fund buys depends on what the fund's objective is. If the objective is growth, the fund may choose more stocks. If it is to pay its shareholders steady income, it may choose bonds and other interest- or dividend-paying securities.
Advantages of Diversifying
Diversification lets you spread investment risk over several companies, industries, and types of securities. By investing in different types of securities, you also minimize the risks inherent in each market. When one market goes down, another may go up. Stocks, bonds, and other assets do not all rise and fall together. Therefore, when you have several different securities in your fund and one of them performs poorly, that one will not overly hurt the whole fund. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.