Good portfolio management demands that we buy baskets of stocks, bonds, and other securities, but most of us don’t have the amount of money it takes to buy the hundreds or thousands of securities across all asset classes to keep our risk down and our expectations high.
Nor do we have the time and expertise to know everything about large caps, small caps, growth, value, treasuries, corporate bonds, emerging markets, international stocks and bonds, and even commodities. But with mutual funds we can participate in all of the above by simply choosing nine or ten good solid funds.
For example, the average stock mutual fund holds around 140 different stocks, which means that if you own four different styles of stock mutual funds, say large cap value, large cap growth, small cap and international, you could be a part owner of nearly 600 companies.
Some of the companies you own will be excellent long-term values, but some will be real stinkers. The good manager will know when to take profits, when to take losses and where to find bargains.
On the other hand, if you only held a handful of stocks, how would you feel if one of those companies went bankrupt? You’d be in a pickle. What if two of your six picks really tanked?
So, diversification within an asset class protects you from the danger that a specific security will suddenly lose value. For example, had you bought Apple at its height last fall, you would have a paper loss of nearly $300 per share, which might devastate a portfolio of only six or seven stocks. Even income investors felt the pain if they happened to own GM or Lehman Brothers bonds back in 2009.
On the other hand, a mutual fund holding Apple along with another 100 stocks might still have made money these last six months, and a bond fund with thousands of bonds would have politely burped and continued on without further indigestion.
Alas, even this much diversification does not protect you when an entire asset class goes out of favor. For example, if I only own the Vanguard 500 fund and the S&P Index goes down 5 percent, my portfolio goes down 5 percent. Even if I own the Vanguard 500 and another Large Cap U.S. fund, if large cap stocks go down, I lose.
So next time we’ll discuss how to diversify across many different asset classes and how funds make it easy.