Diversify Your Stock Funds
What Is Diversification?
Investing is unpredictable. Stocks and bonds go up and down. The markets go up and down. Since the market is unpredictable, we want to make sure we do as much as possible to reduce the risk that we will lose money. One important strategy for reducing our risk of losing money is to diversify our holdings, thereby reducing the impact of any one investment. By purchasing many different investments, investments that behave differently with one going up while the other goes down, we can reduce the effect of any one investment.
Check Mutual Fund Holdings
In most mutual funds, the amount invested in any one company will typically not exceed 5%. To quickly check the quality of a mutual fund's diversification, look at the top ten holdings. If the number of holdings is less than 20 or the amount of any one holding is greater than 10%, you may want to reconsider the fund.
Mutual funds offer us an easy way to diversify our holdings. Most mutual funds hold a highly diversified portfolio of stocks from many different companies. In addition to this form of diversification, we can also diversify our stock holdings by other factors by choosing different types of mutual funds. Two of the most common ways to diversify stock holdings is by market capitalization and by investment style.
How to Diversify Your Holdings
By Market Capitalization
Market capitalization is a measure of the size of a company and investment analysts use this to group stocks into three broad categories - large, mid (for mid-range), and small cap (for capitalization). Many stock mutual funds specialize in only one of these categories. You may determine the target market capitalization of a mutual fund by reading the objective, checking the fund category on the profile, and reviewing the Average Market Capitalization in the fund statistics. As large capitalization stocks are generally less risky than mid and small capitalization stocks, a moderate risk allocation across market capitalization would be something like 50% large cap, 30% mid cap, and 20% small cap. If you have a low to medium tolerance for risk, you may want to reduce the amount you have invested in small cap, since small cap stocks tend to go up and down more than mid or large cap stocks.
By Fund Investment Style
Two types of investment styles are growth and value. Put simply, growth investors look for fast growing companies and value investors look for bargains. Growth fund investment managers will look at market potential and earnings growth to try and identify companies that will grow faster than the average. Value fund investment managers, on the other hand, examine fundamentals to try and identify companies and sectors that are undervalued and therefore are a bargain when compared to the average.
Over time, both investment styles can be useful, so when building a portfolio for long-term investment, it is important to have a mix of these two styles in your portfolio.
International Funds
In addition to the diversification strategies described above, you may want to consider diversifying your portfolio internationally. Adding international funds to your portfolio can help to reduce the risks associated with changes in international markets such as a sudden drop in the U.S. dollar. You may also want to utilize international funds to take advantage of the growth in international markets. International funds, however, are more risky than U.S. stock funds so you will want to be cautious when adding these funds.* A moderate risk portfolio might not have any international funds while a good level for investment in international funds of an all-stock portfolio might be 10% or 15%.
Diversification and the Morningstar Stylebox™
If you are familiar with the Morningstar Stylebox™ 
you may have noticed that the two diversification strategies described here represent the different dimensions of the Morningstar Stylebox. The rows of the stylebox represent the different market capitalization levels: from top to bottom, Large, Mid, and Small Cap. The columns represent fund investment style from value to growth. The middle column is for funds that use a blend of value and growth styles. To identify the capitalization and style of a mutual fund first check the investment object and then the Morningstar Morningstar Stylebox™.
Completing Step 3
It is time to reformat the list of funds by category we created in Step 2. Focus just on the list of equity funds. Separate these funds into the nine categories of the Morningstar Stylebox. Create a separate category for international funds and one last category called special for all remaining stock funds. Using the following calculator decide what percentage of your money you want to put in each of these subcategories. Press calculate and the calculators will show you the actual percentage of your money to invest in each fund within the different categories.
| Balance | |
|---|---|
| % Stock | |
| Stock Fund Diversification | |||||||
|---|---|---|---|---|---|---|---|
| Market Capitalization | |||||||
| |||||||
| Investment Style | |||||||
| |||||||
| % Bonds | |||||||
Press "Calculate" to view your results.
| Investment Style | ||||
| Value | Blend | Growth | ||
|---|---|---|---|---|
| Market Capitalization | Large | |||
| Mid | ||||
| Small | ||||
Now that you have a list of funds in their categories and percent allocations for those categories, proceed to Step 4 — Comparing Mutual Funds
* Risks involved in international investing include currency risk, the chance that a loss of value will occur due to foreign currency; liquidity risk, the chance that an investor will not be able to buy or sell a security quickly enough, or in sufficient quantity, due to a lack of buying or selling opportunities; and political risk, the chance that political upheaval may disrupt economic activity, negatively impacting investments; as well as the usual risks of investing.