The Right Kind of Diversification

By Gregg Wolper | Morningstar

If it seems like there are more funds clamoring for your attention these days, you're not imagining things. Not only has the number of mutual funds expanded by the thousands during the past decade, but numerous exchange-traded and closed-end funds, many of them with very specialized, even exotic, mandates, have also popped onto the scene.

However, it's not just the number of funds that might cause confusion. More and more, investors have been hearing that in order to be properly diversified, they need exposure to more asset classes than they previously had assumed. Instead of just stocks, bonds, and cash, many responsible financial writers and advisors--not to mention fund companies trying to pitch their latest wares--now suggest that a portfolio should also include some real estate and perhaps exposure to commodities as well. And of course, as in the past, you're still told to include among the stocks some smaller companies as well as large, international (and make sure to own emerging markets), and domestic--and both growth and value.

Some investors have responded by owning more and more funds. But the result can be a sprawling, unmanageable portfolio of 20 or 30 funds or more. Others, especially in retirement plans, take the opposite course: They toss up their hands and own just one fund, a target-date vehicle or similar option that provides diversification all on its own.

As my colleague Christine Benz wrote in a past column, owning just a single "all-in-one" fund can work. But not all such offerings are topnotch, to say the least. More important, many of you want to choose funds on your own and feel comfortable taking that responsibility. Yet you don't want dozens of them.

The good news is that you still can own just a few funds and not feel guilty that you are violating the iron law of diversification. The key is to understand that there are two ways to think of diversification.

To Meet Your Goals, or to Win?
Perhaps it's more accurate to say there are two different reasons most investors diversify. The more traditional one is to make sure if losses hit one type of investment that you'll have others that are rising or at least maintaining their value. The second reason for diversification seems to be newer: If you don't own everything, you'll probably miss out on the top-performing sector of the next year or decade.

It is the latter approach that induces people to overload. You may own a good international fund, but you've heard you could miss out on the chart-topping group if you don't also own an international small-cap fund and an emerging-markets fund, not to mention a fund aimed at certain popular markets such as China or India. If you don't have a gold fund, you might similarly miss out if it repeats its dominance of the past decade. That logic could then lead you to buy more funds that invest in other metals or other commodities. A great many such offerings are now available in mutual fund or ETF formats. Who knows which one will crush the competition?

It's true that niche areas can put up spectacular returns, sometimes over extended periods of time. But the purpose of long-term investing is to meet your own goals and provide some psychological comfort during rough spells. The goal is not necessarily to ensure that you get the highest return possible or to top the performance of your neighbor or brother-in-law. The traditional kind of diversification is a conservative measure. The second kind is an aggressive attempt to win a contest.

What It Means in Practice
To be clear, sticking with the old-fashioned kind of diversification doesn't mean you must abandon the idea of owning emerging markets or gold or that you can't take advantage of new kinds of vehicles. And you can do so while owning just a limited number of funds that you've selected for the right reasons.

For example, many good international funds that focus mainly on large caps are wide-ranging in other ways, providing an amount of diversification. For example, you could own Vanguard Total International Stock Index(VGTSX) as your lone foreign-stock fund; at year-end, more than 20% of that portfolio was in emerging markets. And after recently changing its benchmark, it owns more small caps than it used to. Or you could own Thornburg International Value(TGVAX), available through advisors. That fund has few small stocks but typically owns plenty of companies in emerging markets simply because the managers think great opportunities lie there. Moreover, that fund's managers expressly buy stocks fitting into several different areas--traditional value as well as rapid growers--so the exposure there is broad in more ways than one.

Meanwhile, if you've studied the issue and have decided you agree with those who say commodities are legitimately a separate asset class that may hold up well when some of your other holdings are tanking, there's nothing wrong with buying a mutual fund or an ETF devoted to them (as long as you've checked the fund out closely, of course). Conversely, though, it could be self-defeating to buy many different ETFs devoted to various specific commodities not for their potential defensive traits but because you worry that one of them is going to double or triple over the next year or two and you don't want to miss out on the jackpot.

In short, investing for long-term goals is not the same as hoping to win the lottery. A reasonable amount of diversification, with a reasonable amount of carefully chosen funds, can still do the job over time. You won't win any contests. But you'll have a good chance of reaching your goals without too much fuss or worry.

A version of this article appeared Feb. 15, 2011.