What Is the Difference Between a Diversified and Non-Diversified Mutual Fund?

A mutual fund, by definition, is a diversified portfolio of investments managed with a common investment objective. According to the Investment Company Institute, the primary trade group representing the mutual fund industry in the United States, there are 7,961 mutual funds which manage more than $11 trillion dollars. There are many layers and definitions of the word diversification when it comes to mutual funds.

Diversification vs. Non-Diversification

• The reason for diversifying investments is to spread the risk across numerous investments without requiring a large amount of money. For someone to buy every stock that makes the Standard & Poor's 500 Index, for example, it would take a large amount of money since there are 500 stocks in the index. It is easier to buy a mutual fund that does this for you with as little as $3,000. You have lowered your risk by having a small piece of all 500 stocks in the index. There are numerous funds available to mimic every index in the market.

Diversification by Asset Class

• The first layer of diversification is by asset class; in other words, what types of investments are in the fund. The basic asset classes are stocks, bonds, commodities and cash. All investments can be broken down into one of these categories. Each of these categories can be further divided into even smaller sub-groups. The more the sub-groups you break down to, the less diversification you get in the fund.

Diversification by Sub-Asset Class

• Each of the above asset classes can be further broken down into sub-classes. For stocks, you can have large company, mid-sized company, small company, micro-sized company, global funds (includes U.S. companies), international funds (doesn't include U.S. companies), utility funds, European funds, Asia-Pacific funds, emerging markets funds or China funds (among other country specific funds). The more specific the sub-asset class, the less diversified the fund.

Diversification by Sector

• There is also something called a Sector Fund that allows you to invest in one single part of the economy, such as Precious Metals, Real Estate, Energy or Technology. If you make the investment at a time when a particular sector gets hot, such as precious metals in 2007, it can prove to be highly profitable. These are not non-diversified, because these funds can have hundreds of investments from a particular sector. They would be considered less diversified than a general mutual fund.

Combination Funds Diversify For You

• There are also funds that take the guess work out of how to diversify among different asset classes. These are called asset allocation funds. They are managed usually to a specific formula or mix of investments, often in a combination of mutual funds. They include most investment types discussed so far, even some of the sector funds. Investors usually get a choice from lower risk conservative (which has a higher allocation in bonds), moderate, growth and (higher risk) aggressive growth, which has a higher allocation to stocks. These are usually good funds to start with if you have never invested previously.

Be Careful Not to Over-diversify

• It may sound contradictory, but it is possible to over diversify. When an investor has multiple funds, it is important to pay attention to the top holdings for each. If there is too much similarity, you are not accomplishing the goal of diversification. Look to other sectors or company size diversification to give yourself a more effective mix of funds. Most of the information you need to know about different funds can be found on either the Morningstar or Lipper websites. In addition to objective information on funds, you can also order literature from fund companies in order to make an investment.