Some people buy into mutual funds for the safety of a diversified investment; others use funds' broad holdings to manage their investing risk. But those benefits aren't always guaranteed. Consider one fund in particular:

  • It gained nearly 28% in 2003, and delivered market-beating returns of 13% and 14%, respectively, in 2004 and 2005. In 2006, it gained just 11%, while in 2007 it lost 4%. Not bad, eh?
  • But this year, the fund is down 34% as I type this. Over the past week alone, it's down 6%.

The fund in question is Fidelity Select Insurance (FSPCX). As of the end of July, the fund had fully one-sixth of its assets invested in one of the country's biggest and most respected insurers -- American International Group (NYSE:AIG). Its other top holdings included MetLife (NYSE:MET) and Hartford Financial (NYSE:HIG).

By now, we all know about AIG, whose shares have taken just a slight hit in value (to say the least). AIG stock closed at $12.14 per share on last Friday, then at $4.76 on Monday, and then at $2.05 yesterday. 

Lessons for fund investors
What should we learn from this painful example? Here are a few points to consider.

First, beware of high concentrations when you invest in sector funds. Pharmaceutical fans can opt for the Fidelity Select Pharmaceuticals (FPHAX) fund, which owns shares of Johnson & Johnson (NYSE:JNJ) and Abbott Labs (NYSE:ABT), among many others. Just keep in mind that the fund recently had 19% of its assets in J&J and 12% in Abbott. If bad news strikes either one of those companies, the entire fund will take a big hit.

Also, don't assume that non-sector funds are immune to such damage. The Clipper (CFIMX) fund, for example, recently held some 6% of its assets in AIG, its eighth-biggest holding. Its top holding is Costco (NASDAQ:COST), at nearly 11% of assets, and American Express (NYSE:AXP) at close to 8%. The fund is a concentrated one, with about 25 holdings, as opposed to the more typical 100 to 200 holdings of many stock funds. This concentration permits big gains, but also big losses. In general, focused investing lets managers prove their value, but investors should be aware of the risk.

In short, Fools: Be sure you know what your mutual funds are invested in, and make sure you're comfortable with their allocations.

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Longtime Fool contributor Selena Maranjian owns shares of Costco and Johnson & Johnson. Johnson & Johnson is a Motley Fool Income Investor recommendation. American Express is a Motley Fool Inside Value selection. Costco is a Motley Fool Stock Advisor pick. The Fool owns shares of American Express. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.