The Diversification of Mutual Funds

Mutual funds offer cost-effective portfolio diversification.

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Financial asset yields can rise rapidly only to fall precipitously. This is a harsh lesson for people who have staked their financial futures on the earnings of a handful of stocks or the price appreciation and interest payments of a few bonds. A diversified portfolio that is re-balanced systematically is more likely to decrease your exposure to market risk while consolidating and protecting your long-term gains. Mutual funds accomplish this goal by pooling the savings of many investors and making a collective investment in a diversified portfolio of securities.

Individual Investor Portfolio Diversification

The budget constraints of many individual investors preclude their investment in a sufficient number of financial assets to attain the needed level of diversification to limit their exposure to specific issuers, sectors, currencies or countries. Individuals with a large amount of money — a million dollars or more — are more likely to diversify their portfolio, but such investors might incur high transaction fees as they buy and sell a relatively few shares in a large number of companies.

Mutual Fund Diversification

Mutual funds allow you to reduce your exposure to portfolio risk by making an indirect investment in different securities and companies, the diversification of which would be difficult to achieve with the money that most savers have to invest on average. Fund investors effectively own a portfolio in which the risks of individual assets are unrelated or are offset by other assets. A mutual fund accomplishes diversification by buying and holding financial assets and selling shares of the fund's portfolio to individual investors. In turn, investors with limited funds have an interest in a diversified portfolio. As a result, these investors have an opportunity to achieve a better return for a given risk than they would achieve as an individual investor.

Fund Diversification Method

An individual mutual fund may or may not offer a high degree of diversification. For example, sector funds invest solely in the securities of companies in a single industry. Other funds are country- or region-specific. There are also funds, though, that own the stocks and bonds of dozens or more companies, as well as other assets. That arrangement lowers a fund's overall risk by protecting investors from the types of risks that a single company, industry or asset class can face. These funds decrease the chances that investors will be adversely affected by rises and falls in the market.

Balanced Portfolio

Some investors’ diversified portfolios consist solely of stock and bonds. Others include more than two asset classes, such as stocks, bonds, real estate and money market securities. Variety within an asset class and among asset classes is important. Intra-asset diversification is represented by variety within an asset class, such as small-cap stocks and large-cap stocks. Inter-asset diversification is represented by a variety in multiple asset classes. The majority of mutual funds offer intra-asset diversification and some offer inter-asset diversification.