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What is Diversification?

Empty BoxAre you diversified? What is Diversification? In the context of this blog, diversification has to do with your portfolio. Yea but what’s a portfolio?

View a portfolio as a big empty box. We’ll put stuff in this empty box to make up our portfolio. Let’s pick one mutual fund and take a look inside. We’ll pick the Hodges Fund, symbol HDPMX.

I talked about the Hodges Fund in my What is a Mutual Fund? article. If you look at their top 25 holdings they publish every week, some of them include the following:

  • Cisco (CSCO) – Telecommunications
  • Union Pacific Corp (UNP) – Railroads
  • ConocoPhilips (COP) – Integrated Oil & Gas
  • Costco Wholesale Corp (COST) – Broadline Retailers
  • Legg Mason (LM) – Investment Services

Are you seeing the diversification here – Telecommunications, Railroads, Oil & Gas, Retailers, Investment Services. You should be thinking, hey, the one mutual fund we’re talking about is diversified.

In this example, diversification is owning a bit of stocks in many different sectors or industries. So yes, the mutual fund itself is diversified and we haven’t even put it in the box yet, our portfolio. So let’s put it in our portfolio.

The more we diversify our portfolio, the more resilient our portfolio will be to the crazy market swings that we’ve been seeing lately.

The beauty of this for the small investor who doesn’t have tons of money is that the mutual fund offers instant diversification.

Diversification reduces the risk and volatility of investing directly in stocks and bonds which usually don’t move up and down in the same direction at the same time.

If one type of investment is going up and the other is going down, your portfolio or in some cases, just your mutual fund is less volatile.

Now, imagine putting an International Fund into your portfolio. How about a sprinkling of a small cap value mutual fund and a small cap growth mutual fund. Keep going with a large cap value and a large cap growth mutual funds. That’s many levels of diversification within your portfolio.

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