Mutual fund investors have long been advised to strive for diversification in their portfolios. But that goal may seem difficult for a new investor or one who has just a few thousand dollars to invest.
No matter how experienced you are, or how small your investment is, you can still put together a diversified portfolio with a variety of funds such as large-, mid- and small-capitalization, as well as domestic and international and stock and bond funds.
Smaller investors seeking diversification may want to start with life-cycle mutual funds, said Eric Tyson, author of "Mutual Funds for Dummies."
These funds are labeled by date, so investors select them based on when they plan to retire. Investors in their twenties, for example, would buy a 2040 fund, which right now would be mostly stocks but would decrease its equity position and increase its bond holdings as retirement neared.
Along the same lines, there are life-stage funds, which also differ in their exposure to equities, although they don't automatically change their holdings over the years. It is up to investors to move to more conservative funds in the group as they age.
Many fund families, including Vanguard Group and Fidelity Investments, offer life-cycle and life-stage funds.
Tyson also recommends that smaller investors look at balanced funds, which hold both equities and bonds.
Employer-sponsored 401(k) plans also present opportunities for diversification, but investors must guard against holding too much of their company's stock. The collapse of Enron Corp. drove that lesson home. When Enron filed for bankruptcy protection in December 2001, its workers lost about $1 billion in retirement savings that were invested largely in company stock.
Experts say that if 401(k) contributions are matched with company stock, investors should not purchase additional shares of that stock.
Investment pros generally advise investors to devote no more than 15 percent of their portfolio to any single stock, or even a particular asset class such as large-cap growth funds or small-cap value funds.
Many investors have too much invested in large-cap mutual funds, which own shares of large companies such as Microsoft Corp. and General Electric Co., said Paul Merriman, president of Merriman Asset Management in Seattle and publisher of FundAdvice.com.
The large-cap preference is due to the fact that this sector helped fuel the late-1990s bull market. But that ride was an anomaly, Merriman said, as large-cap stocks for the most part have underperformed their small-cap counterparts in the long term. The reason is that there is less risk to investing in bigger companies, and thus the reward is smaller.
"We should not expect to get higher returns in lower-risk investments," he said.
Merriman recommends a systematic approach to diversification in which investors invest in different asset classes over the course of nine years. The plan works best for those investors with individual retirement accounts, because, unlike 401(k) investors limited to the options chosen by their employer, they can pick any fund they want.
The nine classes that Merriman advises investors to commit to over the years, in the order in when they should start investing, are U.S. small-cap value, international small-cap value, U.S. large-cap value, international large-cap value, emerging markets, U.S. small-cap blend, international small-cap, international large-cap and U.S. large-cap.
The idea, Merriman said, is that investors start in areas of the market that historically have the best long-term returns. Over time, shares of small companies have outpaced those of larger companies. In addition, the value style of investing, in which companies pay investors a portion of their earnings via dividends, over the long term has outperformed the growth style, in which companies reinvest profits in the business to grow.
Lastly, investment experts say investors should keep in mind that diversification isn't about the number of funds, for two reasons. The more funds that investors own, the higher their chance of having unnecessary duplication if some funds hold many of the same stocks, and they would have to pay more fees.