Diversifying your mutual fund portfolio

Diversifying your mutual fund portfolio

Diversification

When selecting mutual funds, you should also see how that fund fits into your diversified portfolio.

Diversification is one of the most important things to understand in finance. A properly diversified portfolio is one of the few cases where two plus two truly equals five.

I could talk about diversification using terms like "beta", "covariance", and "modern portfolio theory", but let's take an easier example. Suppose you're a simple farmer who lives near the Colorado River in Arizona.

Diversification - farmer example set up

It's early in the planting season and you're trying to figure out where to plant for the year. In this part of the country there are only two possible weather patterns during your growing season. One is a rainy season, and the other is a dry season. You don't know what will happen this year, but the rainy and dry seasons both have a 50 percent chance of occurring.

You have three locations where you can choose to plant. The first is near the river, the second is on the mid-plains, and the third on the high plateau.

If you plant near the river and it rains, your crop is completely washed away. If you plant on the high plateau and it's dry, the drought destroys your crop.

If you plant on the mid-plains, you'll be OK in either weather but you'll only get four bushels of grain. And this four bushels is the minimum amount your family needs to survive.

But if you gamble and plant all your grain near the river or on the high plateau and the weather turns out in your favor, you win big. You'll get 10 bushels in either location which is more than twice what the safe mid-plains offers.

So, what do you do? Do you play it safe and plant everything in the mid-plains or gamble and plant your grain near the river or on the high plateau?

Answer to the farmer example

If you said play it safe and plant in the mid-plains, you're wrong. The thing to do is to divide your grain in two, and plant half the grain near the river and the other half on the high plateau. This way, come rain or shine, you're guaranteed to get five bushels of grain which is one bushel more than if you played it safe and planted in the mid-plains.

This example is simplistic, but it shows that by diversifying your assets among two risky investments you can get a higher return without assuming more risk.

Look for assets whose returns aren't correlated

You can do this with financial assets in the real world as well. The key is to get assets whose returns aren't correlated with each other. You obviously want to invest in assets that appreciate over time, but on the way up you want one asset to zig while the other one zags.

Diversify across and within asset classes and over time

To get the maximum benefit from diversification, you should diversify across asset classes, and then diversify within asset classes, and also diversify over time.

Investing in stocks, bonds and real estate is a good example of diversifying across asset classes. Stocks, bonds and real estate don't react quite the same to economic news. For example, stocks were pounded in the depression of the 1930s, but bond values actually doubled during that time because of the depression's deflation. Likewise the 1970s were a terrible decade for investing in stocks or bonds, but were great for real estate.

You should also diversify within asset classes. For example, within your bond holdings you should invest in government bonds, mortgage securities, and even junk bonds. Although these three securities are all bond investments, they each react differently to interest rate changes, and diversification protects you against large changes in interest rates.

You also should diversify your stock holdings. I'd hold a variety of small company and large company stocks. I'd also recommend that you put perhaps 20 percent of your equity money into foreign stocks. See my tape on stock investing for more information on foreign stock markets.

Finally, you'll also want to consider putting some of your money into real estate or other hard assets. Most people already own a home, and this is plenty of exposure to real estate for most folks. But if you're a renter, you might want to invest in a real estate mutual fund.

Balanced funds

If you're looking for an easy way to diversify your mutual fund investments, you may want to look into funds that invest in a number of different assets. Most funds invest in only one type of asset like stocks. But there are hybrid funds which invest in a number of different types of assets.

The first kind of hybrid fund is called a balanced fund. Balanced funds generally invest in fixed percentages of stocks and bonds.

Asset allocation funds are similar to balanced funds in that they invest in bonds, stocks and perhaps money market securities. But asset allocation funds try to time the market by switching among the three main asset classes to maximize returns.

The third type of hybrid fund is a so-called fund of funds. A fund of funds invests in several other mutual funds. A fund of funds may own shares in several bond funds and several stock funds.

The fund of funds approach got a fairly bad reputation in the 1960s when these funds charged twice the management fees of normal mutual funds. However, funds of funds are making a comeback in the 1990s. Some of the new funds of funds unfortunately are charging double management fees, but there are other funds of funds that offer great diversification without charging double management fees.