Diversification and Mutual Funds

(6 of 8)

Diversification and Mutual Funds


When you’re ready to begin investing, the concept of diversification is critical. You’ve probably heard the expression "Don’t put all your eggs in one basket." This simple concept is important to helping you protect your investment portfolio as well as create opportunities for growth.

Things To Know

  • A mutual fund is a fund that raises money from investors to invest in stocks, bonds, and other securities.
  • Mutual funds do much of your investing work for you.
  • Diversification is built in to mutual funds.

Let’s consider an example. A stock investor could invest in one company or multiple companies. The risk of investing in one company is that the value of your investment will completely depend on the performance of that single company. While the company being invested in has the opportunity to provide a significant return, they also could fail and the stock could become worthless. By investing in multiple stocks, investors have the potential to reduce their exposure to loss.

Stock investors should also consider investing in different types of stocks. Stocks can be categorized by the size of the company, as well as the type of industry the company competes in. In general, small and midsized companies grow at faster rates than large companies; therefore the value of their stocks has the potential to outperform stocks of large companies. By investing in a variety of different industries, investors can diversify the risk of one or two specific industries performing poorly and having a significant negative impact on their overall stock portfolio.

This same concept holds true for bond investors. Most bond investors purchase a variety of different types of bonds with different maturity dates, interest rates, and credit quality. For example, the risk of putting all of your money into a government bond with an interest rate of 2% that matures in 10 years can be significant. If after two years interest rates have risen to 4%, the bond investor will miss out on the opportunity to earn twice the amount of interest that new bond investors are earning. And if they decide to sell their bond they will have to sell it at a discount to make up for the low interest rate. By investing in multiple government bonds with short, intermediate, and long-term maturity dates, an investor will have funds available at a variety of different dates to take advantage of the potential of earning a higher interest rate.

Mutual funds: Pre-packaged investing

Many investors are comfortable with the risks of investing in stocks and bonds but are not confident in their abilities to select a well-diversified portfolio of these types of securities. Mutual fund investments were created decades ago to provide a solution to this problem.

Mutual funds are a simple, convenient way to invest in stocks, bonds, and cash-type securities. They provide investors access to professional management and broad diversification. In essence, you and many other investors with a similar investment objective are hiring a well-trained group of investment professionals to build a portfolio of securities (e.g., stocks and bonds) for you. Mutual funds are ready-made portfolios of securities designed to achieve specific investment goals. When you buy shares in a mutual fund, you and the other investors participate in the gains and losses of the fund’s investments. All mutual funds come with a prospectus that gives you all the details you need to know in order to make an informed investment decision.

Mutual fund benefits

A mutual fund is a fund that raises money from investors to invest in stocks, bonds, and other securities. It is a package made up of several individual investments. When those investments gain or lose value, you gain or lose as well. When they pay dividends, you get a share of them. Mutual funds also offer professional management and diversification. They do much of your investing work for you.

Professional management. Most investors turn to mutual funds because they do not have the time, knowledge, and capability to research and select stocks and bonds to purchase in order to build their personal investment portfolio. Mutual funds are professionally managed by a team of portfolio managers who are supported by various investment professionals such as research analysts. These professionals continuously monitor the economy, stock and bond markets, the interest rate environment, and the political environment and make decisions regarding how these variables affect the securities in the mutual fund. Additionally they spend a significant amount of their time researching companies they currently invest in or are considering investing in to determine their prospective outlook for continued and growing profitability. At the end of the day, investors are paying the mutual fund managers to determine what securities to buy and when to buy them, as well as when to sell them.

Diversification. When you buy shares in a mutual fund, your money is invested in dozens or even hundreds of securities covering different industries that meet the fund’s objective. It would typically be difficult for an individual to own a portfolio that matches the diversification you’d find in a mutual fund. Owning a diverse mix of securities doesn’t eliminate risk, but it can reduce it because the ups and downs of individual securities may offset each other.

  • A built-in feature. Diversification is built in to mutual funds. Mutual funds collect money from many investors, pool it, and then buy different securities. These investments may include stocks, bonds, and cash-type investments. How much of each type of investment a fund buys depends on what the fund’s objective is. If the objective is growth, the fund may choose more stocks. If it is to pay its shareholders steady income, it may choose bonds and other interest- or dividend-paying securities.
  • Advantages of diversifying. Diversification lets you spread investment risk over several companies, industries, and types of securities. By investing in different types of securities, you also minimize the risks inherent in each market. When one market goes down, another may go up. Stocks, bonds, and other assets do not all rise and fall together. Therefore, when you have several different securities in your fund and one of them performs poorly, that one will not overly hurt the whole fund.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.

Convenience. One of the advantages of mutual funds is that they make it easy for you to buy and sell shares on your own.

Most mutual fund shares can be purchased directly from the fund, through a financial advisor or an employer-sponsored retirement plan. Many investors choose to work with a financial advisor to obtain advice on how to construct a portfolio of mutual funds based on their goals. In return for their advice and guidance, investment advisors receive a commission or fee.

To purchase a mutual fund, you will need to complete an application form. You can also set up an automatic investment plan when you complete your fund application and have money withdrawn from your bank or credit union account each month and sent to the fund.

You can redeem shares by contacting the fund company or your financial advisor and requesting to redeem shares. Many funds allow you to redeem shares over the telephone, but some require written requests. The fund’s prospectus, a document that describes the fund’s investments and performance, also explains your options for redeeming shares.

Mutual fund fees and expenses

Each mutual fund’s prospectus will outline the fees and expenses they charge investors. Be sure you understand these fees before making an investment. Fees can be categorized broadly as follows.

Sales charge: Some mutual funds charge an upfront sales charge when you purchase the fund. This is also referred to as the load. The sales charge varies based on what mutual fund you select, how much you invest, and what type of fund you purchase. A general range of loads is 1–5% of the amount you invest. This fee is in place to compensate an advisor who is providing you guidance or advice. There are many mutual fund options available to be purchased with no "load" (that is, sales charge). This type of mutual fund is sold directly to individual investors and generally does not include investment advice. If you are a do-it-yourselfer, this is likely the route you would take to purchase mutual funds.

Expense ratio: All mutual funds charge their investors ongoing fees to pay for the expenses associated with running the mutual fund. The costs are used to pay the investment manager of the fund and to cover marketing and operating expenses. This fee is expressed as a percentage and can range from as low as .05% to over 2% depending on the fund you purchase. You are not billed for this fee. It is taken out automatically and reduces your return. A high expense ratio can have a significant impact on the growth of your money. Many investment experts would recommend investing in funds with an expense ratio below 1%.

Actively managed funds vs. index funds

To this point we have been discussing managed funds. They are considered actively managed funds because there are a group of investment professionals buying, selling and monitoring the securities in the portfolio for you. They react to what’s going on in the financial markets and make changes to the portfolio as they see fit.

You have probably heard of popular stock indices like the Dow Jones Industrial Average or the S&P 500. These indices comprise a "basket" of stocks from US companies. The S&P 500 represents 500 large companies having their stock listed on the major stock exchanges. Examples of stocks in the index are Apple, General Electric, AT&T, and Facebook. The price of the index is calculated based on the collective prices of the 500 stocks in the index. The S&P 500 is considered one of the best representations of the U.S. stock market, and a bellwether for the U.S. economy.

Investors can choose to invest in index funds also. Index funds are passively managed, which means that their portfolios mirror the components of a market index. In essence, they are on auto-pilot. For example, the well-known Vanguard 500 Index fund is invested in the 500 stocks of the Standard & Poor’s 500 Index. By investing in this type of an index fund, you will own a portion of the 500 stocks in the fund. Investors invest in index funds to take advantage of their low fees (due to no investment manager), ease of purchase, and because they feel the fund will perform as well or better compared to actively managed funds.

There are risks involved in mutual fund investing, so make sure you review your fund’s prospectus carefully and compare its performance to similar funds to make sure you’re getting the best deal.

Would you prefer to watch a video? If so, click here.