How Investment Diversification Works

Mutual Fund Diversification

Mutual funds are wildly popular with investors because they offer instant investment diversification. A mutual fund is a collection of stocks and bonds managed by a team of professional investors and money managers. The professionals do all of the research for you. They pick and choose assets that achieve a desired ratio of risk and growth potential. Even better, mutual funds rebalance themselves!

Mutual funds have their disadvantages, too. Not all mutual fund managers are created equal, so there's no guarantee that your collection of stocks and bonds will make money. Also, not all mutual funds are cheap. Many carry lots of sneaky commissions and hidden fees with disarming names like "back-end loads" [source: Investopedia].

Equity funds are mutual funds that are composed mostly of stocks and are allocated for long-term growth. Within equity funds are a number of subcategories:

  • Index funds are designed to closely mimic a popular stock market index like the S&P 500 or the Dow Jones Industrial Average. As the market goes, so does the mutual fund.
  • International funds can either include different stocks from around the world or stocks concentrated in a specific global region.
  • Sector funds stick to a particular industry like health care or high tech. They are considered risky because so many of your eggs are in one basket.
  • If you don't like the idea of investing in companies that damage people's health or the environment, you can find funds that specialize in socially responsible or green businesses.

Income mutual funds are less risky than equity funds. They invest in mostly government and corporate bonds and are designed for people who are willing to sacrifice growth potential for a steady dividend paycheck. Money market accounts are also a type of mutual fund that only invests in the most conservative security: U.S. Treasury Bills.

Targeted maturity funds are designed for investors who are saving for a particular time-sensitive goal like retirement or paying for a college education. With names like "Target Retirement 2040," these mutual funds are automatically balanced and allocated to maximize return and secure your earnings by 2040 [source: Pulliam Weston].

Take note that if you invest in a mutual fund outside of a tax-sheltered 401(k) or IRA account, you will be subject to capital gains tax each time your fund manager sells assets to invest money in other securities. The best funds for avoiding capital gains taxes are index funds since they require less maintenance [source: Barker].

Now let's wrap things up by considering both the advantages and disadvantages of investment diversification.