The hallmark of any solid investment portfolio is diversification – the spreading of risk through the holding of a variety of different instruments that present varying levels of exposure to risk, and in different industry sectors.
One of the ways to accomplish this is by acquiring investment mutual funds.
Small portfolios that hold only one or two securities usually aren’t concerned with diversification. But it doesn’t take much for any investment professional to recommend that, rather than putting all your eggs into one or two baskets, you accumulate smaller amounts of a greater number of securities.
Spreading the Risk
The rationale is solid and obvious – if one investment in a portfolioi goes south, or if an entire sector (type of investment, or stocks in a given industry) grows weak, the overall effect of the downward pressure on the portfolio will be minimal, or at least spread over the entire value of it.
And if the entire market is going up, chances are most of the securities in the account will do likewise.
One certainly could create diversification simply by researching and choosing stocks from different arenas, and with different levels of risk. But this presents certain challenges, because you’d need to manage the portfolio through various stages of the market, including dividend and reinvestment issues, and the more stocks you hold the more time-intensive that can be.
Or, you could invest in a single mutual fund, or even a few of them, to accomplish precisely the same objectives.
Mutual Funds Defined
A mutual fund is a professionally-managed portfolio of securities (usually stocks, but there are funds comprised of bonds and mixtures of other instruments) that align toward specific goals, such as appreciation or income generation through dividends. The fund may hold dozens of different securities (fund managers are constantly buying and selling stocks within the portfolio in an effort to optimize performance), but you only track one price – the aggregated price per share of the fund itself.
In other words, one share of fund XYZ would buy you fractions of shares in dozens of other companies, all managed by someone who knows what they’re doing. And, who collects an annual fee (usually one half to three quarters of a percent, sometimes more), to do so.
The advantage is precisely the same as if you’d have diversified your own portfolio – if one of the stocks goes south, the entire fund only feels a bump because the others remain relatively stable. Of course, in the case of overall market trends in tumultuous economic times, the entire fund will flow in the general direction of the market.
The ability to outperform the market is the criteria by which you should select a mutual fund, among other variables. Diversification is the common threat among mutual funds, but from there they spread in many directions in terms of objectives, composition and the nature of their management.
Like any investment, it’s buyer beware, as always. But there’s a reason mutual funds are the most common form of stock market participation – they’re easy, and they’re diversified.
