Do: Attempt to understand what you own.

For most investors, the first choice would be an index fund. These same investors will probably opt for the diversified Standard & Poor’s 500 index of the top 500 capitalized stocks on the exchange. Adding to this fund might mean looking at other indices looking for increasingly smaller companies tracked by the Russell 1000 or even smaller capitalized offerings in the Russell 2000. This would be a good way to diversify your portfolio.

The investor is cautioned however to pay close attention when adding actively managed funds to the portfolio. You may find that you own similar holdings in those funds as you might in the index. Diversity, if done properly, spreads the risk of too much exposure in any one investment. The investor needs to understand each new investment they add to their portfolio and how it impacts your quest for a diverse portfolio.

Do: Be cautious adding actively managed mutual funds.

The hallmark of diversification is owning what you want in the amount that is suited to your personal understanding of who you are as an investor. Most index funds own a disproportionate percentage of their portfolios in the top ten companies they track. You could, if you bought another fund that is actively managed and focused on the same group of companies in that index, find that you now own too much of the same company. Owning only index funds spread out over numerous sectors can eliminate this concern and ensure diversity. But adding actively managed mutual funds may undermine that diversity. Read and compare prospectuses carefully to avoid owning too much of one type of investment.

Don’t: Make assumptions based on the mutual fund’s name.

Mutual fund names are designed to tell you what the fund hopes to achieve. Not all names however are as clear as you might think. Here’s an example of a fund, named for the index it tracks that doesn’t own what it suggests it does.

It is easy to look at the title of a mutual fund, such as the Russell 2000 index of small-cap stocks for instance and assume that all two thousand small companies in the index are represented. They are not. Some companies are so small, that if any mutual fund, including indexed funds showed interest in buying the stock, the price might inflate for no tangible reason other than this sudden interest in ownership. You want a stock to increase in price because of good news.

The investor should be researching the charter of the fund to determine if its goal aligns with their objectives. Look beyond the veneer and dig deep into the fund.

Don’t: Own too many mutual funds

Try and limit your mutual fund portfolio to three funds. If you are comfortable with indexing, you can cover the entire marketplace with three purchases such as a large-cap index, and international stock index and a total bond market index.

If actively managed funds are what you prefer, apply basically the same rule but do your homework. You do not however need to drill down too far into what a fund holds; the top twenty securities usually comprise the lion’s share of the holdings on a percentage basis. You should review what those funds do own and whether there is any crossover investments that would create unwanted overexposure.