An important way to reduce the risk of investing is to diversify your investments. Diversification is akin to "not putting all your eggs in one basket." For example, if your portfolio only consisted of stocks of technology companies, it would likely face a substantial loss in value if a major event adversely affected the technology industry.
There are different ways to diversify a portfolio whose holdings are concentrated in one industry. You might invest in the stocks of companies belonging to other industry groups. You might allocate your portfolio among different categories of stocks, such as growth, value, or income stocks. You might include bonds and cash investments in your asset-allocation decisions. Potential bond categories include government, agency, municipal, and corporate bonds. You might also diversify by investing in foreign stocks and bonds.
Diversification requires you to invest in securities whose investment returns do not move together. In other words, their investment returns have a low correlation. The correlation coefficient is used to measure the degree to which returns of two securities are related. For example, two stocks whose returns move in lockstep have a coefficient of +1.0. Two stocks whose returns move in exactly the opposite direction have a correlation of -1.0. To effectively diversify, you should aim to find investments that have a low or negative correlation.
As you increase the number of securities in your portfolio, you reach a point where you've likely diversified as much as reasonably possible. Financial planners vary in their views on how many securities you need to have a fully diversified portfolio. Some say it is 10 to 20 securities. Others say it is closer to 30 securities.
In either case, you'll still pay a lot in brokerage commissions to put together such a portfolio. For example, if the average trade costs $30, assembling a 10-stock portfolio would cost $300 in commissions. Surely, a cheaper way must exist to achieve diversification benefits.
Mutual funds offer diversification at a lower cost. You can buy no-load mutual funds from an online broker. Often, you can buy shares of a fund directly from the mutual fund, avoiding a commission altogether. Mutual funds often require an initial investment of between $1,000 and $2,500. However, they generally allow subsequent investments of as little as $25. The Web site of the Investment Company Institute has a list of mutual funds and their toll-free numbers and websites.
Mutual funds hold hundreds of securities in their portfolios. This provides a diversification advantage that's hard to beat. You do face yearly expenses with mutual funds. Management and marketing fees make up most of the fund's operating expenses, which total about 1.5% of your investment each year.
In spite of yearly fees, owning shares of five or 10 mutual funds with different investment objectives may provide great diversification benefits at a lower cost than building a portfolio of individual stocks and bonds.