Are Your Returns Maximized?

A few years back, checking your email meant navigating through scores of spam mail that reached your inbox. Somewhere in there was an email from your old college buddy; but first you had to find it. Alas, there was the advent of the firewall. With it came the comfort of knowing spam didn't make it to your inbox. But neither did that all-important note from your airline saying your flight was delayed.

It's a fact that automated filters -- whether in your email inbox or your investment portfolio -- miss important distinctions. So have we gone too far?

Ignorance is not bliss
With all the uses for (and news on) different investing strategies, it's perfectly natural for you, the investor, to gravitate toward your comfort zone -- growth, value, or real estate -- and filter other strategies out.

While this inclination may keep you investing in what you know, it's most likely not the best way to maximize your returns. There's risk in concentrating solely on one sector of the market. What if the real estate bubble bursts and you're stuck holding properties that don't appreciate? You'll have years of stagnant money. That's why you need to diversify -- and hedge your portfolio bets.

Diversification is the key
According to modern portfolio theory, smart asset allocation and diversification are the keys to maximizing returns and minimizing risk.

This requires determining just how correlated the asset classes in your portfolio are. To decrease your risk, you want to hold assets whose returns aren't correlated. For example, since stocks and bonds tend to move in opposite directions, it's usually a good idea to have some balance of the two. In other words, by holding both, you should run less risk of total capital loss. This balance will depend on your investment timeline (longer timelines should tilt toward stocks; shorter timelines should tilt toward bonds).

OK, so that part of asset allocation is relatively easy. The more complicated aspect is building a truly diversified stock portfolio. Let's say, for example, that you can achieve diversification by holding a stock from each of these five sectors: small cap, blue chip, international, health, and growth. Here are five stocks we'll use as examples:

An 8% CAGR (compound annual growth rate) over this time period isn't bad for a diversified stock portfolio. But by using mutual funds, you can diversify further and potentially earn higher returns. For example, the following table shows some top-performing funds for the same five sectors:

That's almost 2 more percentage points every year that you could have earned by investing in mutual funds rather than individual stocks. That's because in addition to the returns from great companies above, you enhance your portfolio with the returns of other companies in those sectors. (This is also why mutual fund performance will trail a really high-flying stock.) However, you also minimize your risk and limit volatility by spreading your investment dollars across more than five companies (which is actually quite a concentrated portfolio). Dodge & Cox, for example, is diversified across markets and sectors, holding firms from Royal Dutch Shell (NYSE:RDS-A) to News Corp. (NYSE:NWS).

The optimal performance
Diversification and performance are crucial to the long-term success of your portfolio. If you put up firewalls against certain investment styles, break them down with mutual funds. And since so many actively managed funds lag their benchmarks, it's crucial to consider expense ratios, asset turnover, and management teams in order to find the best performers. That's why The Motley Fool's resident fund geek, Shannon Zimmerman, specializes in finding funds with the lowest expense ratios and the most tenured and best performing management. Want proof? Well, his Champion Funds recommendation of Dodge & Cox International is up more than 65% for subscribers. How's that for results?

Trust me, there is a fund out there that can enhance and diversify your portfolio. Click here to let Champion Funds help you find it.

Motley Fool research analyst Shruti Basavaraj does not own shares of any company mentioned above. T. Rowe Price Health Sciences is a Champion Funds recommendation. Healthways and UnitedHealth are Stock Advisor recommendations. The Fool's disclosure policy will pass any spam filter.