Investment Diversification is one of the basic tools  of building a sound investment portfolio. Diversification is the fancy name for  the advice your mother might have given you:  Don’t put all of your eggs in one basket. This is the basic tenant behind asset allocation, a key diversification tool.

My fellow finance blogger Ken Faulkenberry defines investment diversification as follows:

“Investment portfolio diversification is a portfolio strategy combining a variety of assets to reduce the overall risk of an investment portfolio. “   

A basic look at diversification  

Based on Ken’s definition you could use stocks, bonds, mutual funds. ETFs, private equity and a whole host of assets and asset types in building a diversified portfolio.  In the examples that will follow I am going to limit this to mutual funds investing in stocks and bonds.  Please note that nothing that follows should be construed as advice or a recommendation of any kind.  The mutual funds and allocation percentages used are for example only.  

Let’s start with an investor with $100,000 to invest.  Let’s go back in time to January 1, 2000.  One thought would be to pick a fund that invests in a variety of stocks.  Perhaps the Vanguard 500 Index Fund (VFINX) is a good choice.  How much would an investment of $100,000 have grown to by December 31, 2009, the end of the press has deemed the lost decade?  The answer is that your $100,000 investment would have shrunk to $90,165 for an average annual loss of 1.03% .  Truly a lost decade for this investor.

Let’s say this investor added the following funds to his portfolio:

• Vanguard Small Cap Index (NAESX)
• Vanguard Mid Cap Index (VIMSX)
• Vanguard Total International Stock Index (VGTSX)

How much would an investment of $100,000 invested equally in each of these four funds have grown to by December 31, 2009?  (We are assuming no taxes or rebalancing in this and all examples in this article)  The answer is $137,511.  This is $47,346 or about 52% more than an investment of our investor’s cash only in the Vanguard 500 Index .  Let’s look at the average annual investment returns for each of these funds for the period 1/1/2000 – 12/31/2009: