Mutual funds and stocks are arguably one of the most popular types of investments in today’s market. But even though mutual funds may hold stocks in their portfolio, they’ve long been touted as a safer investment than individual stocks. If you’ve ever wondered why this is the case, this is a post you don’t want to miss.
The main reason mutual funds are safer than stocks is that they make diversification easier to achieve. The other two possible explanations are that risk management decisions are more informed in mutual funds and that some fund types provide dynamic risk management.
Stick around for an insightful discussion as I shed more light on these three explanations for why mutual funds are safer investments than individual stocks.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
Diversification is Easier With Mutual Funds
Diversion is one of the most effective ways of reducing asset-specific risk. It spreads your risk across different assets with varying performance levels, helping cushion your portfolio against fluctuations in individual asset value. In doing so, diversification does more than stabilize your returns; it can also improve them.
While diversification can be achieved with both stocks and mutual funds, it’s generally easier with the latter. Why?
Two reasons:
- The sheer nature of mutual funds
- A diversified portfolio requires less capital to assemble with mutual funds than individual stocks.
Let’s take a deeper look at each of these statements.
The Sheer Nature of Mutual Funds
Naturally, mutual funds are diversified portfolios comprising various assets. They pool funds from many investors and put them to work through securities such as bonds, short-term debt, and bonds.
A mutual fund’s holdings may contain one or a combination of these security types in hundreds, usually acquired from different industries. That means each share of a mutual fund is inherently diversified because it gives you a slice of everything included in the fund’s holdings.
In stocks, each share denotes an ownership stake in one company. As such, creating a diversified portfolio with individual stocks requires you to pool together shares of different companies operating in various industries. This is a time-consuming process because you need to pick the right stocks to invest in, which requires analyzing each company’s:
- Debt to equity ratio relative to industry norms
- Price-earnings ratio
- Leadership
- Strengths and weaknesses compared to its peers.
- Growth trends
- Dividend policy, and much more.
A Diversified Portfolio is Cheaper to Create with Mutual Funds
Typically, optimal diversification is achieved when a portfolio holds more than 20 different securities.
So as an investor looking to create such a portfolio with individual stocks, you’d need a sizable budget. This is particularly true if you’re looking to hold shares of high-performing companies in your portfolio because these usually come at a premium (Case and point? Shares of perennial high performers such as Apple and Amazon).
On the other hand, each share of a mutual fund represents small portions of many securities. And by “many,” I mean way more than the average number (20 to 30 different securities) you’d find in an optimally diversified portfolio. Most funds’ portfolios will hold hundreds or even upwards of a thousand different securities.
So if the fund you choose to invest requires a minimum investment of, say, $500, that amount buys you a stake in a diversified portfolio that wouldn’t be possible to assemble with individual stocks.
Add to that the fact that some funds have no investment minimums and that others like the Charles Schwab Corporation have set the bar as low as $100, and it’s easy to see why diversification requires less money to achieve with mutual funds.
Risk Management Decisions are More Informed In Mutual Funds
Effective risk management is critical to success in securities trading. It’s how you give yourself the best chance of avoiding losses.
For your risk management framework to be effective, it needs to be driven by informed decisions. Otherwise, there may be a price to pay because risk management decisions based on misleading information are almost always costly.
When you invest through a mutual fund, your risk management decisions are likely to be more data-driven than trading individual stocks. This has a lot to do with how funds are managed.
Mutual funds are controlled by expert managers with the skill and experience to choose the most suitable bonds, stocks, and other investment types to buy or sell. In some funds, the manager may be assisted by a team of professionals such as analysts.
Essentially, fund managers and their teams manage risk on the investors’ behalf. Each decision they make is based on comprehensive research and analysis, reducing the chances of making wrong calls that may lead to losses.
As an investor trading individual securities, you likely can’t match the risk management capability of an expert fund manager and his/her team because they have more resources for research and analysis.
Sure, you might be using EDGAR and platforms such as Bloomberg and Kitco to research investments, but an analyst will likely be better at making sense of that data. Also, some of these and other commonly used investment information sources may be useless when looking into overseas companies (especially small ones).
Some Mutual Funds Offer Dynamic Risk Management
Dynamic risk management in mutual funds comes in the form of target-date funds, a class of mutual funds commonly used for long-term goals such as retirement.
Target funds usually have a predetermined maturity date (AKA, the “target date”), and investors have to choose one that matches their investment needs. For instance, an investor looking to retire in 2050 would choose a target-date 2050 fund.
Essentially, a target-date fund adjusts its asset allocation periodically, shifting to a more conservative risk profile as the target date approaches. This is done using the glide path, an asset allocation model that shows how an investment strategy becomes risk-averse towards the end of the investment time horizon.
To demonstrate how that works, here’s an example of how a target fund with a 20-year time horizon would adjust its portfolio risk over its life:
- 0 to 5 years. The fund would typically have a high tolerance for risk. The fund manager, well aware of this, would skew its asset allocation towards high performing but risky assets such as global and domestic equities.
- Year 5 to year 15. The fund manager would gradually shift the fund’s asset allocation from high-risk assets to moderate risk/reward assets. This might mean combining high-risk assets like equities with low-risk securities such as fixed income investments.
- Years 15 to 20. With the target date approaching, the fund manager would shift towards low-risk investments such as cash equivalents and bonds. The final year would see the fund’s portfolio bear the least risk.
As you can see, a target fund provides dynamic risk management that you can’t match when trading individual stocks.
Sure, you can play around with asset allocation in your stocks portfolio over a certain period to lower risk. But even then, your portfolio would still carry significant risk at the end of the investment time horizon (as long as it only holds stocks). That’s because stocks are typically more volatile than bonds and other securities that a target-date mutual fund may use to lower risk.
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Conclusion
As we’ve seen in this post, mutual funds are safer than stocks due to three reasons:
- They make diversification easier to achieve.
- Their risk management decisions are more informed
- Some types offer dynamic risk management.
However, the fact that mutual funds are safer than stocks doesn’t necessarily mean that you should always choose the former. Instead, you can use both to balance your portfolio according to your goals and investing style.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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