It Pays to Hold a Diverse Portfolio : Investments: A mix of stock, bond and money funds is recommended to maximize returns and reduce risk.

Nothing goes further to explain the widespread appeal of mutual funds than the diversification they provide.

In a single package, a fund gives investors with as little as a few hundred dollars access to a broad portfolio of stocks, bonds or other investments.

Investors who wish to diversify further can easily do so by spreading their money over half a dozen funds of different types and brand names.

“Diversification is the best way to maximize your returns and reduce your risk,” notes Value Line Securities of New York in a bulletin to investors in its fund family.

“A mix of stock, bond and money funds will cushion the impact of a stock or bond market correction. Gains in one asset often offset losses in others, while the end result typically is a solid return over the long term.”

This simple idea is close to a sacred principle in the world of investing. But like other great virtues, it can lead to trouble if misunderstood or misapplied.

The problem is that what looks like diversification sometimes does not provide the degree of desired protection. A portfolio of many large growth stocks, for instance, cannot provide much cushion in a period when large growth stocks in general are out of favor, as they have been for the past two years.

A portfolio split between stocks and bonds may suffer almost as much as a less diversified investment if a sustained rise in interest rates weighs down both the stock and bond markets.

After all, stock and bond funds rose together through the early 1990s in response to falling interest rates. So it is clearly possible that they could decline together in a period of rising rates, as they have done in the past few weeks.

Furthermore, funds whose names sound different may not always pursue truly different investment strategies.

“Currently,” said John Rekenthaler, editor of the Morningstar Mutual Funds advisory service, “investors attempting to diversify their domestic stock picks by selecting one top fund from the growth, growth and income and small-company lists will probably land three portfolios stuffed with smallish, fast-growing firms.”

Rekenthaler said a better way to get diversity among stock funds is to pick ones that differ in both the size of stocks that dominate their portfolios and the style they employ--”growth,” “value,” or a combination of the two.

Even then, investors cannot assume that they have bought themselves some sort of impenetrable shield against the ravages of a pervasive bear market.

Over the 12-month period through Jan. 31, five major categories of stock funds tracked by Lipper Analytical Services Inc. showed remarkably similar results.

The returns posted by capital appreciation, growth, small company growth, growth and income, and equity income funds all fell into a band between 15.25% and 16.92%.

If the positive market setting in which these gains occurred were turned upside down, it isn’t hard to imagine all those categories taking parallel downward paths.

The newest rage in fund diversification is to go global with world stock and income funds.

International stock funds certainly have been an enriching addition to almost any portfolio over the past year, climbing nearly 50%. But of course these too could join in a general downtrend should a worldwide bear market occur.

So diversification should be thought of as beneficial, but not magical.

“Construct an all-weather portfolio--blue-chip stocks, small stocks, different maturities of bonds, even some gold stocks or real estate,” advises Richard Graber, senior vice president at Jones & Babson, manager of a fund group in Kansas City.

“It isn’t necessary to invest every dime in common stocks, but keep enough of your portfolio there at all times to take advantage of future bull markets. Never become so cautious as to take away all of your opportunity for growth.”