Into Mutual Funds? Be Sure to Diversify
Diversification is a big attraction for many investors who choose mutual funds. Here’s an example of why: Suppose you heard that Phenomenal Pharmaceuticals (example name) has developed a drug that stops cancer cells in their tracks. You run to the phone, call your broker, and invest all your savings in shares of phenomenal stock. Five years later, the Food and Drug Administration denies the company approval for the drug and the company goes belly up, taking your entire nest egg with it. Your money would have been much safer in a mutual fund.
A mutual fund might buy some shares of a promising, but risky, company like Phenomenal without exposing investors like you to financial ruin. A fund owns stocks or bonds from dozens of companies, diversifying against the risk of bad news from any single company or sector. So when Phenomenal goes belly up, the fund may barely feel a ripple. It would be difficult, and expensive, to diversify like that on your own, unless you have a few hundred thousand dollars and a great deal of time to invest. You would need to invest money in at least eight to twelve different companies in various industries to ensure that your portfolio could with-stand a downturn in one or more of the investments.
Mutual funds typically invest in 25 to 100 securities, or more. Proper diversification increases the probability that the fund receives the highest possible return at the lowest possible risk, given the objectives of the fund. We are not suggesting that mutual funds escape without share-price declines during major market downturns. For example, mutual funds that invested in U.S. stocks certainly declined during the October 1987 U.S. stock market crash. However, the unhappiest investors that month were the individuals who had all their money riding on only one or a handful of stocks. Some individual stock share prices plunged by as much as 80 to 90 percent.
During 2000, many mutual funds declined in value when technology and Internet stocks were especially hard-hit. Again, the investors who were most harmed were those who held individual stocks that, in the worst cases, ended up plummeting to $0 as companies went bankrupt. Although most mutual funds are diversified, some aren’t. For example, some stock funds, known as sector funds, invest exclusively in stocks of a single industry (for instance, health care). Others focus on a single country (such as India).
It’s also worth noting that investors who bought sector funds investing exclusively in Internet stocks got hammered in 2000. Many of those funds dropped 50 percent or more, whereas broadly diversified funds generally fell less than 10 percent that year.