DIVERSIFICATION COMES UP a lot in these essays. Take a look at our section on Risk vs. Reward: It's basically a paean to the notion that diversifying your investments will protect you from the market's worst storms. The more types of stocks or bonds you own, the less any one of them can hurt you by tanking. Excessive dependence on just a few investments is always asking for trouble.
Yet building and maintaining a diversified portfolio isn't for everybody. To do it right, you might have to keep an eye on as many as 20 to 60 different stocks and bonds at once. Some people thrive on this sort of thing, but others lack the time, interest or experience to give a complex portfolio the attention it demands. For them, the financial industry invented mutual funds — pools of stocks or bonds that are managed by professional investors.
Funds come in all shapes and sizes, from Fidelity's $53 billion Magellan Fund to the $12 million Women's Equity Fund. Most of them work this way: A sponsor company like Fidelity or Vanguard rounds up money and pays a portfolio manager to buy groups of securities according to a specific investing strategy. The company then sells shares in the fund to the general public at a price reflecting the value of the pooled securities. Buy a share of the fund, and you own a small percentage of the total portfolio, meaning you participate in any of the fund's investment gains or losses. Depending on the fund, you can own a piece of 20 to 500 different companies for a minimum investment of $1,000 to $5,000 — sometimes even less.
You may have to pay a fee for the service, but a good fund offers plenty of advantages. Ideally, the pros have years of experience and are given access to piles of industry and company research. It's also true that unlike a bank certificate of deposit or an annuity, a mutual fund investment is completely liquid, meaning you can get in or out simply by picking up the telephone.
As for diversification, think of this example. In December 2001, a simple portfolio of five stocks that included the one-time Wall Street darling Enron would have crashed mercilessly as questions about the energy firm's finances ultimately led it to seek bankruptcy protection. But a mutual fund portfolio of 100 stocks would have hardly budged on the news.
Remember, though, that while diversification can buffer them from the tyranny of one plummeting stock, funds are still subject to market risk. If the broad market drops, in other words, your fund will usually sink right along with it. Worse yet, there are plenty of lousy funds out there that charge you a lot in fees, and do badly even when the market does well.
As we mentioned in the introduction, roughly 55% of all equity mutual funds routinely fail to beat the returns of the benchmark S&P 500 index. That's why it's essential to choose your funds wisely and strategically. You must learn to recognize the different types of funds out there (see Style Search) and discover how to avoid excessive fees (see Cost Control).
