Mutual funds have long been touted as some of the safest investment vehicles, especially when compared to stocks. But while that’s true, the reasons behind this claim aren’t always clear. Have you’ve ever wondered why so many investment forums and online resources keep suggesting mutual funds as a safer bet?
Mutual funds carry less risk because of three main reasons. First, they provide instant diversification to the investors. Second, mutual funds eliminate guesswork from investments. Finally, based on an investor’s risk tolerance, there are different mutual fund types to choose from.
Stick around for an enlightening discussion as I explain in greater detail why mutual funds may be a safer investment for you.
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!
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3 Reasons Why Mutual Funds Might Be Safer for You
Listed below are the top 3 reasons making mutual funds a safer investment for some people:
Mutual Funds Provide Instant Diversification
Diversification is one of the oldest tricks in the book when it comes to reducing portfolio risk. If you ask any investment-savvy individual about the best ways to reduce risk in any securities investment, they’ll likely name diversification in the top three一it’s a hard lesson that the financial crisis taught everyone.
At its core, diversification is all about “not putting all your eggs in one basket.” In terms of securities investments, it means that you should put your money to work in different industries and investment vehicles.
Portfolio diversification helps reduce unsystematic risk, one of the two broad risk categories identified by financial theory. The other category is known as unsystematic risk.
Before we continue, let’s quickly define each type of risk:
- Systematic risk: Systematic/market risk affects a whole market or a significant portion of it. It’s beyond the control of a company or individual and is usually caused by external factors like political events. Market risk is inherent in all security investments and can’t be mitigated via diversification.
- Unsystematic risk: Also referred to as specific risk, unsystematic risk affects a particular company or industry. It’s caused by industry/company-specific events such as the emergence of new competitors, product recalls, regulatory changes, and so on. You can mitigate this type of risk through diversification.
So how does investing in mutual funds reduce unsystematic risk, then?
As a general rule, a portfolio needs to hold about 20 stocks from various companies in dissimilar industries/sectors to achieve optimal unsystematic risk reduction. With such a mix of stocks, most unsystematic risk is diversified away.
The problem is, capital limitations and brokerage commissions can make it almost impossible to buy into 20 or so stocks at once when you’re starting out. This means you’re more likely to hold fewer stocks, which reduces your level of diversification and subsequently increases your portfolio risk.
This is where mutual funds can be a godsend.
When you invest in a mutual fund, you buy into a pool of well-diversified investments. Thus, even the small amount of capital you can afford to raise can buy you a stake in a fund with investments in as many as 30 different securities across various industries. This instantly adds diversification to your investment, lowering your risk from the word go.
Professional Fund Management Eliminates Guesswork
Sound decision-making is another crucial element of risk reduction for any investor. The more informed your investment decisions are, the lower your chances of making costly mistakes.
Mutual funds are run by professional money/fund managers. These people are usually industry experts with enough experience and knowledge to make better investment decisions than average investors. The fund manager may also be backed by a team of experts such as:
- Risk modelers
- Fundamental analysts
- Technical analysts
In short, buying into a mutual fund puts your money in the hands of a team of investment professionals with more experience and expertise than you might have. This takes a lot of guesswork out of your investment decisions, subsequently reducing your risk of incurring losses.
To show you much guesswork a mutual fund’s professional management eliminates, let’s take a look at the alternative: trading stocks independently on the open market. Some of the decisions you’d need to make include:
- Figuring out asset allocation, diversification, and rebalancing.
- Choosing stocks for companies with a growth trajectory that aligns with your investment strategy. This usually requires extensive research, part of which may be setting up meetings with each company’s management and studying financial statements.
- Selling/buying based on prevailing/anticipated market trends.
As you can see, there’s a ton of decisions to be made in each of the above activities. And while that might seem like a lot to take on, it’s only the tip of the iceberg when it comes to decision-making in stock trading. It’s also why even people who spend entire careers in the stock market aren’t entirely immune to losing money on their investments.
The bottom line? Even though a mutual fund’s professional management doesn’t guarantee positive returns, it gives you a better chance of avoiding losses.
Various Fund Types Serve Different Risk Tolerance Levels
Different investors have varying risk tolerance levels. Some are risk-averse, while others can stomach high levels of investment risk in the hope of high rewards.
Ideally, you want to choose an investment option that matches your risk tolerance level. This way, you can optimize your risk/potential return balance to a level that you’re comfortable with.
Mutual funds come in many forms that cater to various asset classes. For example, we have equity funds, bond funds, money market funds, balanced funds, index funds, and specialty funds. We also have fund types geared towards specific financial goals, such as retirement plans.
With so many options, you optimize your risk level by investing in a fund type that aligns with your investment strategy and goals.
To show you what I mean by this, let’s look at three scenarios where you might choose different mutual fund types to match your risk level to the time horizon of their goals (i.e., long term, midterm, and short term goals).
Choosing Mutual Funds for Long-Term Goals
When your financial goals are decades away, potential short-term losses are less significant because you have enough time to ride out temporary dips in the value of your investments.
As such, you want to choose a mutual fund type that positions your investment for maximum growth in the long run. Sometimes, that may mean tolerating substantial short-term risk that may come with such a choice.
Growth funds are a perfect example of such mutual funds and are often preferred by long-term investors. Typically, funds of this type invest in companies with higher than average growth potential. Sometimes, such companies may not be performing too well presently, and ownership stakes in them may carry more risk short-term but have a high gain potential long-term.
Choosing Mutual Funds for Mid-Term Goals
Mid-term investment goals are those that you want to achieve in five to ten years. As an investor with such goals, you should be looking at fund types with moderate riskーnot too low that it overly diminishes potential and not too high that you may come up short when it’s time to cash in.
Balanced funds may be ideal here. That’s because these types of mutual funds invest in both stocks and bonds, which helps counteract some of the risks that usually come with stocks.
Choosing Mutual Funds for Short-Term Goals
As a short-term investor, you want to minimize short-term risk. As such, you may be better off investing 30% in stock mutual funds and putting the rest of your capital to work through bond funds.
This way, you’ll have a steady income from your bond fund’s interest payments and still give your investment a chance to grow through the stock component.
As you can see from the above scenarios, the sheer types of mutual funds available make it easier to manage risk. That’s because there’s more than one asset class in mutual funds, which can’t be said for stock investing.
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Conclusion
In conclusion, mutual funds reduce the risk for investors by providing them a professionally managed diversified portfolio that potentially meets the requirements of their specific investment goals.
Even though any form of investment will carry some market risk, mutual funds can help minimize this assumed market risk for most investors, especially the ones that are more hands-off.
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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