This tendency for different types of funds to move in and out of favor creates both a risk and an opportunity for investors. The risk is that by putting all your eggs in a single basket, it is possible to continually miss the better-performing fund categories. This normally happens with investors who see a particular type of fund doing well, and move a big portion of their money to that hot category just in time for the market to leave it behind and start favoring another type of fund. Statistics that measure the amount of money moving into each risk category show that much of the investing public makes this mistake, over and over again, resulting in performance considerably worse than that of the market averages.
However, for those who understand the importance of diversification — meaning those who have at least some of their money spread across all of the risk categories — this type of market variation provides an opportunity. Chart E shows how a portfolio invested evenly between the four risk categories performed over the same 20 years.
Not only were the average returns better than three of the four individual categories, but they were attained with lower volatility than all but category 1. In other words, a diversified portfolio provided returns that were virtually just as good, or better, than each individual risk category, while also creating a smoother ride.
Rather than continually trying to chase the hot fund group, simply allocating even amounts to each risk category turned out to be a more effective, not to mention less stressful, approach. Higher returns with less risk: that's the winning combination proper diversification offers.
© Sound Mind Investing
Published since 1990, Sound Mind Investing is America's best-selling financial newsletter written from a biblical perspective. 
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