| One of the biggest benefits of mutual funds is | | | | have diversified away company-specific risk. Full |
| that they provide the means for individual | | | | diversification within a market, in theory, eliminates |
| investors to achieve broad diversification in their | | | | all company-specific risk, leaving your portfolio |
| investment portfolios. Although many wealthy | | | | exposed only to systematic risk, which is the risk |
| individuals and institutions use mutual funds as at | | | | inherent in the market as a whole. So, that brings |
| least the core of their portfolios, having | | | | up the obvious question: What is The Market? |
| considerable wealth is not necessary to construct | | | | The S&P 500, Russell 1000 and Wilshire 5000 |
| a well-diversified portfolio with mutual funds. | | | | are often used as proxies for "The Market." But |
| Indeed, it's possible to assemble a well-diversified | | | | they're only proxies for the U.S. stock market. To |
| portfolio of mutual funds with as little as $100,000, | | | | be fully diversified, you would have to be invested |
| a fairly well diversified portfolio with $50,000 and | | | | in all of the publicly traded securities (stocks, |
| an adequately-diversified portfolio of index funds | | | | bonds, real estate and commodities) worldwide |
| with much less. | | | | and your investments would have to be broadly |
| Having a well-diversified portfolio is important for | | | | diversified within all asset classes in that |
| three reasons. First, diversification can best be | | | | aggregation. This can actually be achieved by |
| described as not putting all of your eggs in one | | | | holding a collection of index funds. |
| basket. Mutual funds are large diversified portfolios | | | | Asset allocation describes how your capital is |
| and thus provide automatic diversification within | | | | distributed to the diversity of asset classes you |
| their respective asset classes. Investing in a | | | | have chosen to hold in your portfolio, i.e., your |
| number of mutual funds to spread your investable | | | | investment universe. If you had chosen full |
| funds across a variety of asset classes increases | | | | worldwide diversification, your next step would be |
| your level of diversification and decreases your | | | | to determine how to allocate your capital across |
| aggregate exposure to risk. As investment risk is | | | | that aggregation of asset classes. One possibility |
| measured in terms of volatility, decreasing | | | | would be to hold what's known as the Market |
| aggregate risk decreases the volatility of the | | | | Portfolio. To do this you would have to invest in all |
| value of your portfolio, thus sparing you the roller | | | | those asset classes on a market |
| coaster ride that you would experience if you held | | | | capitalization-weighted basis. That would by |
| only a single asset class in your portfolio, such as | | | | definition be an efficient portfolio and constructing |
| large-cap domestic stocks. | | | | such a portfolio is possible with index funds. It's |
| Second, although expected return diminishes with | | | | also possible with regular mutual funds, but getting |
| risk, the relationship is disproportionate and favors | | | | and maintaining the appropriate weightings would |
| return. Well-conceived diversification has the | | | | be pretty tricky and require a lot of time and |
| potential to considerably reduce the aggregate | | | | effort. |
| risk of your portfolio at the cost of a relatively | | | | Beyond the Market Portfolio, there are just about |
| small reduction in your expected return. So you | | | | as many ways to select asset classes and |
| get a much smoother ride for a minimal cost. | | | | allocate capital as there are portfolio managers, |
| Third, over the past 25 years or so, there have | | | | investment advisors and newsletter editors. |
| been a number of studies conducted that have | | | | Although they're mostly based on the same |
| concluded that asset allocation accounts for | | | | financial theories, everyone has their own model |
| between 90% and 96% of your success as an | | | | and their own forecasts to fuel their models. But |
| investor, where success is defined as maximizing | | | | going any deeper into asset allocation would |
| return at a level of risk that is consistent with | | | | diverge too far from the topic of this |
| your level of risk tolerance. Individual security | | | | article...diversification. |
| selection accounts for the rest of investors' | | | | In real estate it's location, location, location. In |
| long-term success. Now, just being broadly | | | | investing it's diversification, diversification, |
| diversified won't get you into that 90% to 96% | | | | diversification. You must be adequately diversified, |
| range, but it's a big step in the right direction. A | | | | otherwise you will be exposed to too much risk |
| viable model that defines the composition of an | | | | with respect to your expected return. And no |
| efficient portfolio is required to allocate your | | | | asset allocation model can compensate for |
| capital across the various asset classes in a | | | | under-diversification, as your chosen degree of |
| manner that will reap the full benefits of | | | | diversification defines the investment universe |
| diversification. | | | | across which asset allocation must take place. |
| Diversification and asset allocation are not | | | | With thousands of mutual funds to choose from, |
| synonyms, as diversification is just a part of | | | | there's no good reason for anyone to be |
| asset allocation. Diversification is a matter of | | | | under-diversified. |
| degree; it describes the degree to which you | | | | |