With a mutual fund, you instantly have exposure to lots of stocks, and someone else—the fund manager—makes all the buy/sell decisions. If any one stock tanks, it eats up only a little bit of the money you invested. That minimizes your risk.
There are many reasons that investing experts and the mutual fund industry tout mutual funds over stocks for individual investors. For me, it basically comes down to this: Funds are safer. If you want diversification and the relative safety that comes with it, it’s easier to get that by choosing funds rather than by building a portfolio stock by stock. Here are a few reasons why.
Stock Picking Is Tough Stuff
Fund buyers don’t have to pick stocks. That’s a welcome relief, because successful stock picking is a tall order. If you’ve tried it, you’ve probably learned this yourself. If you haven’t already discovered how difficult successful stock picking is from your own experience, then you need only look at the track record of the majority of mutual fund managers in this country (who get paid to pick stocks) to reach the same conclusion. By and large their record is not good, which is not that surprising: It’s extremely tough to find a winning stock, to buy it low and to sell it high.
Do the names Sunbeam, Global Crossing, or Enron sound familiar? These are all companies that once were adored by investors—both novices and even some experts—but some ended up in bankruptcy court thanks to accounting problems and related alleged misdeeds. Their downfalls whacked investors who thought they were doing the smart thing by buying shares in these once widely respected outfits. And it’s not just bad apples that tank. There are plenty of examples of less infamous but equally steep declines. How many people bought Cisco Systems at $70 when they thought the networking giant was invincible, only to see its stock price drop steadily following the tech wreck that began in March 2000 to $11.04, after the terrorist attacks in September 2001 and lower still, to $8.12 in October 2002? Or how about America Online, which was as high as $95.81 shortly before it agreed to purchase “old” media company Time Warner? Two and a half years later it had lost 82 percent of its value. Then there’s General Electric, perhaps the closest anyone thought they could come to a sure thing. Its value was cut in half between August 2000 and April 2002. I point out these stock stories not because stock picking is impossible, but because it’s very difficult. I’m in the business, and I don’t pick stocks for myself. Nor would I hire just anyone to do it for me. Many professionals don’t succeed at stock picking. Robert Olstein, manager of the Olstein Financial Alert fund, is one of the managers who has beat the S&P 500 Index in recent years, putting up double-digit returns every full year for the six years after his fund launched in 1996, even in 2000 and 2001 when the broader market lost ground. Yet while Olstein has a great record, not every stock pick is a winner.
You Can Manage Risk More Easily with Funds
There are two main kinds of risks you encounter with the stock market (and again, the same goes for the bond market): market risk and specific investment risk. Market risk is the risk that the whole market takes a turn for the worse, thanks to, say, a recession, oil crisis, high interest rates, or war. The only real way to protect against market risk is to keep at least some of your money out of the market.
The second risk is specific investment risk. Specific investment risk is the risk that the stock you own will deflate or blow up due to its own problems. The analogous risk in a fund is that the returns in your particular fund will plummet: The market does fine, but your fund doesn’t. With both stocks and funds, quantitative metrics can help you size up specific investment risk. A stock’s “beta,” for example, measures its sensitivity to a certain market benchmark like the S&P 500 stock mar- ket index. It indicates how far a stock has moved, historically, compared with the S&P, which has a beta of 1. If a stock has a beta of 1.3, it’s likely to move 30 percent more, higher or lower, than the S&P’s move. A beta below 1 means a stock has been less volatile than the index. Likewise, a fund also has a beta based on the weighted average beta of its stock holdings.
These measurements are based on historical data. They are an attempt to predict the future based on the past. But because the future is unpredictable, they aren’t always right. Things go wrong. No matter how reliably a stock behaved in the past, it can still crumble. No business—and that’s what you’re buying when you buy stocks—is a sure thing. A lousy CEO, a crooked accountant, an incredible competitor all can mean the demise of a once viable company.
Equity mutual funds, in contrast, hold many stocks. In fact, this diversification is required by law. The Investment Company Act of 1940 provides that a diversified mutual fund, for at least 75 percent of its assets, may not make purchases that cause more than 5 percent of the fund’s total assets to be in any one company or that cause the fund to own more than 10 percent of the outstanding voting shares of any one company.
Because of this, investors can greatly minimize specific investment risk through funds. If a fund has 100 stocks and five tank, those tankers can only have so much of an impact on the total returns. Ninety-five positions that do better balance out the five losers.
For example, if you wanted to invest in health-care companies from January 1997 through April 2002, you could have spread your risk by putting your money in the Vanguard Health Care fund rather than a specific pharmaceutical company. During that period, Bristol-Myers Squibb rose a paltry 7 percent while Pfizer nearly doubled. But if you were in the Vanguard fund instead, you hedged your risk. Not to mention the fact that the Vanguard fund had a cumulative return of 190.73 percent during that same time—better return, less risk.
All this doesn’t make funds risk free. A manager, for example, might buy lots of stocks in a risky sector. But that’s a risk you can prepare for— a risk you can manage. You can look at the fund manager’s historical record, the types of stocks he or she has bought, the kinds of swings the portfolio has experienced over time. You would also learn that sector funds (or what I like to call special teams that are actually funds focused on a specific industry) can be very dangerous and should be kept to a minimum in your portfolio.
If you study this historical data, you can grasp your real potential downside loss. And you can decide whether you’re prepared to handle it. If the fund has had fairly consistent returns over several years, the odds of an out-and-out blowup of the entire fund are lower than for the same thing happening with one stock. Unless the fund management has a sudden shift in style—and that’s something you can pick up on if you monitor your investments—you’ll have a much better chance of avoiding a whacking with funds than with owning a few individual stocks or bonds.
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