Diversification Through Mutual Funds
Where we left off in the last article, Where To Invest Your IRA Contribution, we assumed you have $5000 sitting in a money market fund while you decide how to split the money between stocks and bonds. In that article, I wrote about asset allocation, which means dividing your money between stocks and bonds. This is one form of diversification. Diversification basically means “don’t put all your eggs in one basket.”
Individual Stocks vs. Mutual Funds
Back in the 1950s or 1960s, if you were going to invest in the stock market you would purchase shares of individual companies–AT&T, General Electric, U.S. Steel, etc. A stock portfolio might consist of half a dozen individual stocks.
The problem with owning only a few individual stocks is lack of diversification–all your eggs are in only a few baskets. If the price of one of your holdings went way down, you would lose a large chuck of money. The way people dealt with this risk was to only buy “Blue Chip” stocks–shares of the biggest and best companies. But lo, the safety of blue chip stocks turned out to be an illusion. Plenty of blue chip companies have gone bankrupt. One example was Penn Central which went bankrupt in 1970. In more recent times Enron and WorldCom went out of business and their stock became worthless. And of course General Motors in 2008.
There is an important lesson here: Any individual stock can go to zero. Don’t put a lot of money in any single stock. Diversify across many stocks.
Mutual Funds Provide Diversification
So nowadays, most investors allocate money to stocks through mutual funds. What are mutual funds? They are holding companies that pool money from many investors and buy a collection of stocks. A mutual fund may own 50, 100, 500 or even thousands of different stocks. If one stock becomes worthless, it is only a small percentage of the whole fund.
Active vs. Index Funds
Today, there are generally two kinds of stock mutual funds: active funds and index funds.
Index Funds. Index funds are easy to understand. An index fund, such as the Vanguard S&P 500 (symbol: VFINX) simply owns every stock in the index that they are tracking. There are lots of different indexes that cover different parts of the stock market, and lots of index funds. Vanguard Total Stock Market Index (symbol: VTSMX) owns over 3,000 U.S. stocks and tracks the entire U.S. stock market. Vanguard Total International Stock Market Index (symbol: VGTSX) owns over 1,700 foreign stocks in Europe, Asia and Emerging Markets. (Emerging Markets means developing countries like Brazil, Russia, China, India and Eastern Europe.) There are many other indexes and index funds.
Active Funds. With active funds, the fund managers try to pick stocks that are going up and avoid stock stocks that are going down. In other words, they are trying to outsmart the market. Most mutual funds are actively managed. Over any period, some active funds beat the market and some fall short. History has shown that very few mutual fund managers can consistently beat the market, and it is hard to know in advance which funds will beat the market over any period.
Expense Ratio
One of the few thing you have control over when selecting a mutual fund is the expense ratio.
Mutual funds have operating expenses like paying the salary of the fund managers, paying for office space, lights, computers, office staff, etc. These expenses come right out of the mutual fund. The higher the expenses, the more money is taken out. Further, most mutual funds are part of a large fund family, such as Fidelity Investments or American Funds. Many fund families are public companies with shares that trade on stock exchanges. These for-profit companies are required to maximize the profit for the owners. They are motivated to have the highest expense ratio that the market will bear.
My suggestion is to only purchase funds with a low expense ratio. How low is low? The Vanguard Total Stock Market Index Fund (symbol: VTSMX) has an annual expense ratio of 0.16%. (Some people say 16 basis points. One basis point is 1/100 of a percent.) That means that if you have $10,000 in the fund your expenses are just $16 per year. Some mutual funds have expense ratios that are 1% or higher. One percent would be $100 annual expenses.
No Load Funds
Some funds charge a sales load when you buy the fund. With load funds, a fee is subtracted from your investment so you start out with less than you put in. For instance American Funds Capital Income Builder A (symbol: CAIBX) has a 5.75% load. On a $10,000 investment, that would be a $575 sales commission. You would immediately have only $9,425 in your account after the sales load was deducted. My suggestion is to avoid load funds.
Summary
- For diversification, use mutual funds instead of individual stocks.
- Only consider low-cost mutual funds with a low expense ratio and no-load.
- Decide if you want to match the market with index funds, or roll the dice with active funds.
At this point, I am assuming you still have $5000 sitting in your money market fund while you decide how to split your money between stocks and bonds. The more stock, the higher the risk of loss. Keeping thinking about how much your are prepared to lose. Meanwhile, next time, I’ll write more about the different kinds of mutual funds.