Your Money_ The Missing Manual - J. D. Roth [128]
If you own just one stock, your fortunes are wholly dependent on what it does. So smart investors diversify (see the box on Mutual Funds) and build portfolios containing many stocks and bonds. You could build a portfolio of stocks and bonds yourself, but doing so properly requires a lot of time, effort, and money. For most people, it makes more sense to invest in mutual funds, explained next.
On The Money: Don't Put All Your Eggs in One Basket
One way investors reduce risk is through diversification, which means not putting all your money into one investment, whether it's a stock or bond or something else altogether. By spreading your money around, you smooth out the market's wild ups and downs while getting a similar return on your investment.
You can diversify your investments in several ways, including:
Within asset classes. The more different stocks you own, the better your diversification. Same goes for bonds.
Among asset classes. In general, the movements of stocks, bonds, commodities (The Tools of Investing), and real estate aren't strongly correlated; for example, just because the stock market is down doesn't mean the real estate market will be down, too. The same is generally true of the returns on these asset classes—they're normally independent of each other. (But sometimes, as in the recent financial crisis, there's a whole lot of correlation going on!)
Over time. "Risk is also reduced for investors who build up a retirement nest egg by putting their money in the market regularly over time," writes Burton Malkiel in The Random Walk Guide to Investing. By using techniques like dollar-cost averaging (see All-in-one funds), you ensure that you're not investing all your money when the market is high.
There are other types of diversification, too. For example, when you buy foreign stocks, you're diversifying by geography.
How much should you diversify and how should you do it? There's no one right answer—it depends on you and your financial goals. To learn more about this concept, check out this guide from the U.S. Securities and Exchange Commission: http://tinyurl.com/SEC-assets.
Mutual Funds
Mutual funds are collections of investments. They let people like you and me pool our money to buy small pieces of many investments. There are a lot of benefits to doing this, including:
Diversification. For less than a thousand bucks, you can buy shares in a mutual fund that owns pieces of every company on the stock market. Such broad exposure reduces your risk, and it's something you couldn't possibly achieve on your own.
Focus. There are over 10,000 different mutual funds available in the U.S. alone. You can find funds that buy stock only in companies that support the environment, or that follow Biblical principles. You can buy bond mutual funds or funds that invest only in Canadian companies. You name it, there's probably a mutual fund for it.
Professional management. When you own a mutual fund, somebody else does the research and buys and sells the stocks so you don't have to.
Because mutual funds offer these advantages to individual investors, they've soared in popularity over the past 25 years. But they're not without drawbacks. The biggest is cost: With stocks and bonds, you usually pay only when you buy and sell, but mutual funds have ongoing management costs. (You don't pay these costs directly; instead, they're subtracted from the fund's total return.) Some of these costs are obvious, but others aren't.
Note
The U.S. Securities and Exchange Commission (SEC) has a run-down of various mutual-fund fees and expenses here: http://tinyurl.com/SEC-costs.
One obvious cost listed in every mutual fund's prospectus (the booklet describing the fund) is the expense ratio, which is the mutual fund company's total annual cost for things like advertising and managing the fund. The company passes these costs on to investors.
Other costs are subtler; you have to look to find them. For instance, funds are required to reveal their portfolio turnover rates—how often they buy