Asset Allocation and Diversification in Mutual Funds
Most people own some mutual funds through their 401(k), another retirement plan or various other assets. The mix of various funds, and the components within each fund, are critical to developing the proper balance in your investment vehicles
Asset allocation is the term used to describe the act of putting monies in different “baskets,” such as cash equivalents, bonds or equities (stocks); all of which perform differently at different times in the economy. In general, returns on different asset classes do not move in the same direction. That is, a decline in bonds may spur a rise in stock prices or vice versa. Often the top performers in one year are down the next. Asset allocation can greatly affect your overall return. Some experts estimate that 90 percent of your overall return depends upon proper asset allocation.
Diversification, on the other hand, is a risk management technique that mixes a wide variety of investments within an asset category. A typical investor thinks that if he has three different mutual funds, then he is diversified. Many people found out in the early 2000s that their funds were not at all diversified because the underlying stocks or bonds within each fund were virtually the same. It’s like buying three cans of mixed fruit only to find out that each can contained exactly the same number of pears, apples and grapes.
It is important to have money in different assets, but it’s as important also to have as much diversification as is prudent within these asset classes. For example, within the equity (stock) portion of your investments, it makes sense to have some funds that take advantage of large company stocks, small company stocks, value stocks, growth stocks and perhaps foreign stocks. True diversification with mutual fund holdings requires that an investor own funds that invest in securities significantly different from one another.
