Suppose a company makes an acquisition, or spins off a division, or fires a chairman. Mr. Molitor said. It's tough to say, even if you're doing the homework. For someone not willing to make the commitment of extra time and effort, it's a lot more sensible to stick with an actively managed fund, where somebody is paid to make those judgments, or to invest in a broad-market index fund, where you get pure diversification at very low cost. Of course, the virtue of diversification applies to a portfolio made up of mutual funds as well.
Funds concentrating on just part of the market carry significant risk.
Mr. Molitor recommends having the core of your portfolio in a broad-market index fund or a handful of funds that collectively cut across asset classes, sectors, and investing styles, with little overlap. This approach should capture the broad market's returns while reducing the volatility that a narrowly focused portfolio can suffer. Then there are those who go to the other extreme. In pursuit of diversification, some investors wind up buying so many funds that they defeat their purpose, Mr. Molitor said. That's because mutual funds' holdings or investing strategies often overlap.