Mutual funds are an excellent way to diversify your investments.
Instead of buying shares in a handful of blue chip companies, for instance, you can buy a mutual fund that owns hundreds of stocks.
For example, if you choose a fund like the Vanguard 500 Index Fund that invests in 500 of the largest U.S. companies that comprise the Standard & Poor’s 500 Index (the S&P), you’ll get instant exposure to household names such as Apple, General Motors, Johnson & Johnson and Facebook.
Why is diversification important? It wouldn’t be necessary if the market always favored blue chip stocks or small-cap companies or Treasury bonds. No one, however, can predict which assets will be on top each year or even each quarter.
For many people, a basic, diversified fund portfolio includes these four asset classes:
How you diversify with these and other asset classes will depend on a variety of factors. Here are some questions to ask yourself:
What are my investment goals?
What is my time horizon for each of these goals?
How much risk am I comfortable with?
Will I be investing in a retirement or taxable account or both?
How are my investments allocated now?
Some investors buy funds based on short-term performance, which is never a good idea.
In the long run, how you fare as an investor greatly depends on the mix of stock and bond funds that you hold. If you own too many similar (i.e., hot) funds, your portfolio assumes too much risk. Many individual investors don’t realize that they own lopsided portfolios.
Resist the temptation to look at your holdings through a pinhole. For example, the object isn’t to diversify just your 401(k) among the funds available in your workplace. You need to look at all your holdings, including a 401(k), IRAs and taxable accounts.
By doing this, you can patch holes in your portfolio. Suppose, for example, that your 401(k) menu doesn’t offer a small-cap fund, you can compensate for this omission by investing in one of these funds in an IRA or some other account.
Be sure to check a fund’s expenses because they can have a tremendous effect on a fund’s performance. In many cases, the funds charging the lowest fees are also the ones sporting the best returns because low fees give funds a huge built-in advantage. This is why 95% of all flows over the past decade, according to Morningstar, have gone into funds in the lowest-cost quintileopens PDF file . Index funds have benefited disproportionately from this trend.
You can determine how much your fund is charging you by looking at its expense ratio, which refers to the percentage of your investment that is automatically taken out of your fund assets to pay for fees.