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I think that diversification within a 401(k) should be aproached with an asset allocation strategy as much as possible. A 100% investment in an S&P 500 fund may be diversification among large cap equities, it most certainly is not 401(k) portfolio diversification.

Our 401(k) includes a money market (guaranteed) feature, bonds, equities divided among large, small, growth and value, international stocks, and real estate. This is a fairly decent mix of asset types. The general theory would involve building the portfolio so that it includes assets that have a low correlation to each other. That is that historical returns for these assets have shown a tendency to move in opposite directions. The result would tend to smooth out the bumps in volatility while keeping returns pretty much intact. An example of two asset types generally having a high correlation would be a large cap equity and a small cap eguity. An example of two asset types generally having a low correlation woulb be large cap equities and real estate.

Regarding pauleckler's comments on international equities not being a good diversivication choice for US equities, I agree that as time goes on these two groups seems to be moving more and more in step with each other. More so than they had in the past. I still believe, however, that they are a better diversification choice for say, large US equities than US small equities.

A caveat. In most cases best results for investing outside a 401(k) type account would be some type of focus portfolio where companies are chosen one by one on the basis of a margin of safety between intrinsic value and market price. This is true since there is more freedom for the investor to determine which investments provide this margin of safety outside the 401(k) rather than inside the 401(k) due to the limited say the investor has in what the mutual funds invest in.
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