Mutual funds are the investment world's egalitarian version of an inexpensive, high-mileage car. Almost anybody can afford to invest in one, they're relatively easy to understand, and they're a novice-friendly way to gain some hands-on experience. Of course, like those popular cars, you have a whole lot of mutual funds to choose from -- thousands, in fact, with different investment styles and objectives. For example, diversified and non-diversified funds are radically different in their workings.
About Mutual Funds
Mutual funds vary pretty widely in their details, but they all follow the same basic model. They gather together contributions from a large number of small investors, forming single large pool of investment capital. The capital is used to purchase a diversified portfolio, making it harder for a downturn in any one sector or type of company to seriously dent its overall holdings. The fund's investors benefit from professional management of their money, as well as more diversity than they could muster by investing directly. However, some funds are more diversified than others.
Styles of Diversification
There are several ways to diversify a portfolio. One of the most fundamental is by allocating portions of the fund into different classes of product, referred to as asset allocation. This breaks down the portfolio among stocks, bonds, interest-bearing certificates and other investment vehicles. Another approach to diversification invests across many regional economies, so that downturns in one region or one country can't cause the overall portfolio too much disruption. A third form of diversification takes the process one step further, finding diversity within individual asset classes.
Diversity Within Asset Classes
Individual stocks are the backbone of most mutual funds, and there is a great deal of variation among them. Owning a high-flying "blue chip" stock representing a famous brand is very different from holding a position in a startup company in a brand-new sector. Generally speaking, the riskier the stock, the higher the return it can generate. That's why a mutual fund invested primarily in equity stocks can still be considered diversified if it contains a carefully considered mixture of stocks with different characteristics. The same holds true for bond funds, which can hold anything from rock-solid U.S. government bonds to high-risk "junk bonds."
Many funds diversify enough that you can hold them as a stand-alone investment and still be protected from the ups and downs of the markets. However, some funds deliberately narrow their focus in specific ways. These non-diversified funds, or less diversified funds, are intended to bring balance to a larger portfolio by focusing on investments with specific characteristics. They might focus on the economies of newly emerging industrial countries, for example, or on the rise of a new technological sector. Another strategy invests heavily in a sub-class, such as small-capitalization companies. All of these strategies deliberately limit their diversity in search of higher gains than more diversified funds can generate.
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