Diversification in Mutual Funds: What It Is and Isn't

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Diversification in Mutual Funds: What It Is and Isn't

If you’re having friends over for a barbecue, would you only serve meat? Even if your guests are all diehard carnivores, they’re probably sophisticated enough to expect more than just protein. Instead, you’d probably offer an assortment—some salad, watermelon, maybe lemonade, and so on. In short, you’d diversify your table so that your guests would be satisfied.

Why you’d want to diversify your investments

Now consider investing. You want to own various types of funds so that your portfolio, as a group of investments, does well. Certain types of investments will do well at certain times while others won’t. But if you have enough variety in your portfolio, it is pretty likely you’ll always have something that is performing relatively well. Owning various types of funds can help reduce the volatility of your portfolio over the long term.

Let’s say that you buy a value fund that owns a lot of cyclical stocks—stocks that tend to do well when investors are optimistic about the economy. If that were your only fund, your returns wouldn’t look very good during a recession. So you decide to diversify by finding a fund heavy in food and drug-company stocks, which tend to do relatively well during recessions. By owning the second fund, you attempt to limit your losses in an economic downturn. That is the beauty of diversification.

What diversification isn’t

Diversification isn’t a magic bullet.

Having a diversified portfolio doesn’t mean you’ll never lose money. Diversification doesn’t mean complete protection from short-term dips or market shocks. Diversification does not guarantee that if one investment goes down, another investment will go up—it isn’t a seesaw.

Here’s an example of why

The year 2008 illustrated this point. The height of the financial crisis was an absolutely wretched time for investors; the average U.S. stock fund lost almost 39% that year. The average foreign-stock fund lost 45%. Funds that bought emerging-markets stocks were down 55%. Real estate funds tumbled almost 40%, while precious metals funds slid 30%. Even bond funds (with the exception of Treasuries) were in negative territory.