Diversification is your most important defense against market risk. Your goal should be to maintain a diversified portfolio at all times. Select mutual funds that include many different companies in each portfolio category. Avoid investing in sector funds or industry funds, individual stocks, or concentrated portfolios of any kind until you have sufficient education, experience, and assets. Even then, keep the percentage of these assets low in relation to the amount of your overall assets.

There are four main factors that determine whether a mutual fund is sufficiently diversified: numbers, concentration, types of assets, and location.

Numbers: Numbers refers to the total amount of holdings or securities that are in the fund. You want to select a fund that is broadly diversified by many securities and industries. Check the number of holdings in the fund (see Table 25.1). If the fund has only 15 holdings, it is not very diversified and you should understand carefully each of those 15 companies. If the fund has 506 holdings (like the Vanguard 500 index fund), it is much more diversified. Since there are over 500 companies in the portfolio, and since no company is a significant portion of the portfolio, it is not as critical that you know about the companies in the portfolio.

Concentration: What percentage of the fund is allocated to the top ten holdings? If 50 percent or more of the fund is invested in the top ten holdings, then the fund has a high concentration in these holdings. If only 21 percent of the fund is invested in the top ten holdings, then the fund has a lower concentration in these holdings and your risk is most likely spread out over many companies.

In addition, by looking at the top twenty-five holdings of a mutual fund, you can see the twenty-five largest stocks the fund holds and the percentage of net assets, or value of the portfolio that each stock comprises. In the example below, the largest stock held is General Electric at 3.41 percent of net assets. Generally, the lower the concentration in the top ten or twenty-five holdings, the lower the risk of a problem with a single company, and the better for most investors.

Table 25.1
Morningstar Website: Diversification

Type of assets: What types of assets are in the fund? If the mutual fund is an equity fund or a bond fund, then all assets should be of the same asset class. However, if the fund is a balanced fund, an asset-allocation fund, or life-cycle fund, you should examine the percentage of the fund that is allocated to stocks, bonds, and cash. Again, the more diversified the fund in terms of its holdings of different types of financial assets, the less volatile the fund will be.

Location: Where is the location of the companies that are included in the mutual fund? The more diversified the locations, the less risk to the fund. Companies from different geographical areas are subject to different business cycles; hence, these companies should experience highs and lows at different times in the investment cycle.