If there is one ingredient to successful investing that is universally agreed upon, it is the benefit of diversification. This is a concept that is backed by a great deal of research, market experience, and common sense. Diversification reduces risk. Risk to investors is frequently defined as volatility of return—in other words, how much an investment's return might vary over a year. Investors prefer returns that are relatively predictable, and thus less volatile. On the other hand, they want returns that are high, but higher returns are accompanied by higher risks. Diversification eliminates some of the risk without reducing potential returns.
Mutual funds, because of their size and the laws governing their operation, provide investors with diversification that might be difficult for an individual to duplicate. This is true not only for common stock funds, but also for bond funds, municipal bond funds, international bond and stock funds—in fact, for almost all mutual funds. Even the sector funds that invest only within one industry offer diversification within that industry. The degree of diversification will vary among funds, but most will provide investors with some amount of diversification.
Continue to Step 3 »
