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Diversifying investments
improperly can carry
pitfalls

YOU'VE probably heard that it's important to diversify your investments, and it's true. By spreading your money among a range of financial vehicles -- stocks, bonds, government securities, certificates of deposit -- you can give yourself more opportunities for success and you'll reduce the chances of being hurt by a downturn that primarily affects one type of asset. So, here's the big question: How do your diversify?

You'd need to spend a great deal of money to build a diversified portfolio piecemeal. Consequently, you may want to invest in mutual funds, which, by definition, offer significantly more diversification than investments in solitary stocks or individual bonds.

Each mutual fund contains dozens, or even hundreds, of securities. So it's tempting to think that the more funds you own, the better diversified you'll be.

But that's not always the case. Suppose, for example, that you are interested in "growth" funds -- those mutual funds whose investment goal is long-term capital appreciation. These types of funds invest heavily in stocks of growing companies that are more likely to reinvest their profits into growing their business, rather than paying cash dividends to shareholders. Although there are hundreds of different growth funds, many of them look alike. So, if you bought several growth funds, you would probably wind up with many similar stocks in slightly different packages. And if one of your funds is adversely affected by market circumstances, the others might be similarly hit, so you could end up losing the key benefit of mutual funds: diversification.

How can you avoid buying a bunch of nearly identical growth funds? Review the prospectuses or annual reports of all the funds you're considering. These documents typically list their funds individual holdings and the percentages of different types of assets.

So far, we've mostly discussed growth funds. To create a diversified mutual fund portfolio, though, you'll need to consider other types of funds, such as the following:

» Growth-and-income funds: As the name suggests, growth-and-income funds strive to achieve a mix of capital growth and current income. These types of funds invest in dividend-paying stocks and some bonds.

» Bond funds: You can find mutual funds that focus on corporate, Treasury or municipal bonds. While all these funds seek to provide income, they differ in risk level and tax consequences.

» International funds: International funds invest in stocks in non-U.S. companies. Although such funds can achieve large gains, they are frequently volatile, as they are subject to currency fluctuation and other risks inherent in foreign investments.

Not all types of mutual funds are particularly helpful in building a diversified portfolio. For example, some investors purchase "sector" funds, which primarily invest in the stocks of a particular industry or segment of the economy, such as technology, health care or financial services. Sector funds are, by design, less diversified than other types of mutual funds; as a result, they are generally more risky.

With the thousands of mutual funds available, how can you choose the mix that is right for you? You might want to get some help. A qualified investment adviser -- someone who knows your goals, risk tolerance and time horizon -- can help you pick the number and variety of funds that best meet your individual needs.