How to Accomplish Complete Diversification with Mutual Funds
by Shane Flait, ©2011

Diversifying your portfolio reduces the risk that the demise of any one company, investment area or market will rob much of your portfolio’s value. But how do you approach diversification especially if you have a limited amount of money. Here’s an approach using mutual funds.

Classically, your portfolio should be divided principally between equity, income and cash investments. Those are the big three investment areas. They tend to behave differently. So you should spread your money between these areas.

But diversification within each investment area is still essential to minimize unnecessary risk to failing companies or market sectors. Purchasing a sufficient number of stocks for your equities and bonds for your income not only requires a lot of money but a lot of time to choose and manage them well. That’s the problem.

Using mutual funds you can achieve that diversification without an inordinate amount of money and yet save yourself a lot of management time too. That’s because each share represents hundreds of actual companies and the fund has a manager who works to grow and preserve the fund’s portfolio.

Mutual funds target all sorts of investment areas – some are specific to a market segment, some to a whole market.  So how many mutual funds should you invest in to cover your portfolio diversification needs?  Let’s take the 3 investment areas – equities, bonds and cash equivalents – and analyze one way they can be broken down into their submarket areas which you can target with a single mutual fund.

Equity Investments

One way you can break down equity investments is into domestic large stocks, intermediate stocks, and small stocks.  Choose a mutual fund that targets a diversification within each of these areas.  For further diversification, you should consider a mutual fund targeting international large stocks in industrialized countries and another one targeting a diversification of emerging stocks in the Pacific Rim area.  Together, that makes five mutual funds to cover a diversified rendition of all equity investments.

Income Investments

Interest rates affect the value of bonds – short term bonds the least, and long term bonds the most. So choose bond funds that target intermediate maturity bonds. That’d be in the three to 10-year range. Choosing this maturity-weighted bond mutual fund will give you some of the long term yields, but show reduced volatility when interest rates change.

Consider municipal bonds in your state for tax free earnings if you’re in a high tax bracket. Or just keep your high-interest-rate bond mutual funds within your tax-sheltered IRA. Choosing one or two differently targeted bond mutual funds should be sufficient.

Cash Equivalent

A money market mutual fund will give you easy access to your cash and its value remains constant like the cash it represents. You may choose it as part of a family of funds to make it easy for you to transfer money to and from your equity or bond funds. One money market fund should be enough for you.

All in all this gives you about 8 mutual funds- five in equity, two in bonds and one money market fund - to keep you well diversified. Beyond this, you can choose a favorite investment or speculation of yours, such as gold or some technology sector, to invest in for your own interests. Buy a mutual fund targeted to one of these after you invest in the 7 or 8 other funds above.

Whether you pick an index fund or a managed fund depends on how efficient the market is in each area. Large-stocks tend to be well monitored so an index fund for them may be appropriate. This is not so for small or emerging stocks. Consider actively managed funds for them.

The intermediate maturity—in other words, a three- to 10-year weighted average maturity for the bonds in the portfolio—captures most of the yield of longer-term mutual funds with much less volatility when interest rates change.

Remember if you are considering an investment in any type of mutual fund please carefully consider investment objectives, risks, charges, and expenses before investing. For this and other information about any mutual fund investment, always obtain a prospectus and read it carefully before you invest.

Shane Flait is a writer and educator. Get more info at www.EasyRetirementKnowHow.com