How Mutual Funds Make Diversification Easy

 
 

REDUCING INVESTMENT RISK

Last week, I took readers through an important walkthrough about the role that risk plays in investing.

In short, the only way we can generate a high enough return for our financial goals is to invest in assets that do contain risk. However, we can reduce risk significantly by practicing diversification, the principle of spreading your money out across several investments at once. By doing this, you can effectively lower the volatility in your portfolio of investments - meaning you won't see as drastic swings in the value of your investments - but still achieve an expected return that's high enough to fund retirement and other long-term goals.

I noted that we can categorize investments into similar groups called asset classes, and that asset classes tend to "behave" differently from each other. In a given year, one asset class - say, stocks of large US companies - might be doing terribly, but perhaps stocks of small European countries are doing so well that it not only offsets your under-performing investments, but creates a gain in value.

Where I stopped short was in describing a practical way that investing in entire asset classes is usually accomplished by young, individual investors like you and me.

Because buying a bunch of single stocks on your own is no easy endeavor.

APPRECIATING THE DIFFICULTY OF SINGLE-STOCK INVESTING

If you were to go out and try to assemble a good collection of US Large stocks on your own for part of your portfolio, for example, you'd be dealing with prices like this:

Amazon Stock Price

Oh, you know. It's only $832 for ONE share of Amazon stock. (In case you're curious, Amazon has over 475 million shares of stock that are traded around on the market).

As you can see, this creates a problem for most individual investors: you're not investing enough money at once to be able to buy shares of several different stocks and bonds every time you have money to invest. So assembling a portfolio of individual stocks one-by-one is cost-prohibitive to the average investor.

The other problem is that you need to be researching, analyzing, and buying several different stocks and bonds of various types (asset classes) to be truly diversified. Even if you had a ton of money to invest, how long do you think that would take you to implement? Tens, if not hundreds of hours each year - it would be a full-time job! I don't know about you, but I don't have that kind of time. Thus, we can see that buying and selling individual stocks is too time-prohibitive for the average investors as well.

So what's the solution? You've probably heard of it before, but perhaps you can gain a more fundamental understanding.

MUTUAL FUNDS ARE WHERE IT'S AT

The conundrum of the average investor who wants to be properly diversified is solved by mutual funds.

For a well-explained definition, let's turn the time over to Investopedia:

 
 

Mutual funds are exactly what they sound like: a bunch of people mutually funding a large pool of money that is big enough to buy shares of several investments. 

Mutual funds are designed by large investment companies, not by the mass of investors who are pooling their money together. You've probably heard of some of these mutual fund companies before: Vanguard, Fidelity, and BlackRock might ring a bell.

These companies assemble hundreds of mutual funds with endless combinations of investments. For example, nearly every mutual fund company will have what's called an "S&P 500" index mutual fund, which will invest your money across 500 of the largest companies in the U.S. Another mutual fund might consist entirely of smaller US stocks, or stocks in first-world foreign countries, or U.S. real estate - the list goes on!

Some mutual funds are structured to just capture an entire asset class, or index. Using these kinds of mutual funds, you can create your own portfolio of several asset classes Other mutual funds even come up with their own allocation between different asset classes. For one, a mutual fund with the word "Balanced" in it usually is some combination of 60% stocks and 40% bonds, with each of those two broad categories being split up into smaller categories.

When you put your money into a mutual fund, you are technically purchasing shares, of the pool of money. And so, as the investments in the mutual fund earn a return, you get your proportionate share of the growth. When the investments in the mutual fund earn dividends, that money is generally to purchase more shares of the mutual fund.

It's crucial to understand the two main philosophies behind mutual fund design (and investing in general), so let's take a quick look.

ASSEMBLING YOUR OWN COLLECTION OF MUTUAL FUNDS

I've gone over how mutual funds make diversification feasible for individual investors, allowing you to invest broadly in several asset classes at once.

Now, the questions you probably have are 1) What mutual funds / asset classes should I invest in, and 2) in what proportions?

Those two questions make up the basis behind asset allocation - how you split up your portfolio between different mutual funds that each represent an asset class. While that's an article for another day, if you're looking for some great in-depth learning about asset allocation then here's an awesome lecture given by Dr. Craig Israelsen of the 7Twelve Portfolio about investing in different asset classes using mutual funds. 

For now, here are a few simple rules to follow when picking mutual funds: 

  1. Understand the "active vs. passive" debate, but that most evidence supports passive investing. Active mutual funds will have higher expense ratios, or fees, because they are frequently buying and selling and switching out investments in an effort to "beat the market". This means trying to get a better investment return than what you'd get for owning all the stocks in the entire market (both the "winners" and the "losers", which we don't know for sure beforehand in any given time period). Passive investors know about the notion that a blindfolded monkey throwing darts at a stock chart may pick stocks as well as (or better than) most active mutual funds - an idea that originally started out as a joke in a famous book but has been supported by research in recent years.
     
  2. Keep fees low. If you take $100,000 and invest it in a mutual fund that gets an 8% annual return over 30 years but has a 1% expense ratio, you'll end up with $761,226. But if you take $100,000 and invest it in mutual fund that gets 8% annual return but only has a 0.26% expense ratio, you end up with $936,071 - that's $174,846 more! Small differences in fees over time make a gargantuan difference on the end value of your portfolio.
     
  3. Ignore short-term returns. When you look at a list of mutual fund options, you will be tempted to look straight at whichever ones have the highest return in the most recent period of time. It's not uncommon for one asset class to have a crazy return over everything else in any given year. But remember that it doesn't last, and that over time, every different part of the market has its time in the limelight. Because you don't know when anything will start or stop performing well, you need to diversify!

These three rules will allow you to avoid the most common pitfalls of mutual fund selection.

All-in-all, using mutual funds is the most feasible way for the average individual investor to get diversified properly and passively ride the returns of the market to reach their goals.

Any tactics you choose to follow beyond that (presumably because you still think there's something you can do to beat the market) should be done with great caution, under the advice of a professional, after a lot of due diligence, and in limited amounts

Until then, let mutual funds be your guide!