Funds are broken down into various categories. Here are a few you should look at:
By size. For the best diversification, you want to buy stock funds that invest in companies of different sizes - that is, small-cap, mid-cap and large-cap companies. You can do this by choosing three different funds that invest in each sized company. Or you can choose one broad fund that invests in all of them at once, perhaps via a stock index fund.
By type. If you think that small growth stocks are going to outperform the market, you could invest in a fund that chooses only growth stocks. If you think value stocks are the way to go, you could select a fund that invests in those stocks. For more, see What are the different types of stocks?
By region. You also want to buy stock funds that invest in companies not just in the United States, but overseas as well. You can do this by adding an international fund to your mix. (Make sure you know what you're buying. An international fund might invest in stable regions like Europe, or it might invest in riskier "emerging markets" regions, such as Latin America, Eastern Europe and mainland Asia. Or it could do all of the above.)
By sector. You could also invest in a "sector" or "specialty" fund that holds stocks in just one industry, such as energy, technology or financials. There's nothing wrong with devoting a percentage of your total stock holdings to such funds, as long as you remember that a hot sector one year could crash the following year. If you do choose to buy such funds, make sure the rest of your stock fund holdings are well diversified. That will limit your overall risk.
