For years, financial experts have repeated the mantra of diversification as a way to smooth out the ups and downs of your portfolio. Yet, many people who believe that they have a diversified set of investments couldn't be more wrong -- and they're carrying much greater risk than they may think.

The benefits of mutual funds
Mutual funds have helped millions of investors diversify their holdings even with relatively small amounts of money. By pooling your money together with other investors, a typical mutual fund gives you a small piece of dozens or even hundreds of different stocks. With minimum investments as low as a few hundred dollars, you can create a portfolio that would require huge amounts of money to duplicate using 100-share lots of individual stocks.

But as useful as a single mutual fund is in helping you diversify, combining a bunch of funds into your overall portfolio won't automatically make you more diversified. If you own too many of the same general type of mutual fund, then you're going to have a more concentrated portfolio than you think -- and you could have some big gaps in your asset allocation.

Different funds, same stocks
To illustrate the point, take a look at these three different funds:

  • The Vanguard US Growth Fund (VWUSX) invests in U.S. companies with promising growth prospects.
  • The Fidelity Select Technology Fund (FSPTX) focuses on companies within the technology sector.
  • The California Investment Nasdaq 100 Index (NASDX) is an index fund that seeks to track the performance of the Nasdaq 100.

Especially to those just starting out investing, each of these three funds looks like it has a different purpose in a fund portfolio. But when you look closely at the top five holdings of each of these funds, you'll notice something peculiar:


Top 5 Holdings

Vanguard US Growth

Google (NASDAQ:GOOG), Hewlett-Packard (NYSE:HPQ), Apple (NASDAQ:AAPL), Gilead Sciences (NASDAQ:GILD), Qualcomm (NASDAQ:QCOM)

Fidelity Select Technology

Microsoft (NASDAQ:MSFT), Hewlett-Packard, Apple, Google, Qualcomm

California Nasdaq 100

Apple, Qualcomm, Microsoft, Google, Gilead Sciences

Source: Morningstar.

Of course, more experienced investors might realize that the Nasdaq is made up largely of technology stocks, and that most tech stocks fall into the growth category. And of course, the Vanguard fund has plenty of non-tech companies further down the list, including Wal-Mart (NYSE:WMT). But without checking your holdings, you may end up with a false sense of security -- when in reality, you're dangerously overinvested in technology or some other sectors.

What to do
Luckily, once you start looking, it's not difficult to get plenty of information about mutual funds. Here are some tools you can use to make sure you're properly diversified:

  • Look for different asset classes. If you own several different funds, but they all concentrate on large-cap U.S. stocks, then the odds are good that you'll have a lot of overlap. Make sure you have at least one fund that covers other asset classes, including small caps and international stocks.
  • Use different fund companies. Sometimes, a given manager will share his stock picks and research across different funds within the same fund family. To increase the chance that you'll get a diverse set of investing ideas, seek out funds from different managers across a range of fund families.
  • Fill in the gaps. By looking at your fund's periodic reports, you can determine what areas a fund focuses on and which sectors it tends to avoid. If a fund is light in one particular sector, then you can get exposure either through a sector-specific fund or with a more general fund that has a focus in that sector.

Diversification is important, but just because you own a long list of funds doesn't necessarily mean you're diversified. In order to avoid the risk of owning a more concentrated portfolio than you think, be sure to look at your fund's holdings on a regular basis and make sure there's not too much overlap.

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Fool contributor Dan Caplinger has no problems with diversification. He doesn't own shares of the companies mentioned. Google is a Motley Fool Rule Breakers selection. Apple is a Motley Fool Stock Advisor recommendation. Microsoft and Wal-Mart are both Motley Fool Inside Value picks. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy isn't dangerous.