Stock funds reduce risk and increase returns

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There's really no way around it: Invest in stocks, and you expose yourself to risk. But that doesn't mean that you can't work to minimize unnecessary risk. One of the most effective risk-reduction techniques is diversification — owning lots of different stocks to minimize the damage of any one stock's decline. Diversification is why mutual funds are such a great way to own stocks.

Unless you have a lot of money to invest, you can only cost effectively afford to buy a handful of individual stocks. If you end up with a lemon in your portfolio, it could devastate the returns of your better performing stocks. Companies are quite capable of going bankrupt. Even those that survive a rough period can see their stock prices plummet by huge amounts — 50 percent or more — and sometimes in a matter of weeks or months.

Even with the extended bull market in recent years (a bull market is one in which stock prices are rising; its opposite is a bear market), certain individual stocks have taken it on the chin. A good example is the technology stock ATC Communications, which was widely touted on Internet message boards in late 1996 after a seven-fold rise in price over the prior year. After peaking in the mid- 20s in October 1996, the stock plunged more than 90 percent in a matter of months and didn't rebound. Problems can take many years to develop as well. IBM was once considered to be among the more reliable and safe blue chip stocks. After trading as high as 175 in the early 1980s, it plunged 77 percent to a low of almost 40 in 1993. As of this writing, it's up to about 115.

Of course, owning any stock in a company that goes bankrupt and stays that way means that you lose 100 percent of your investment. If this stock represents, say, 20 percent of your holdings, the rest of your stock selections must increase about 25 percent in value just to get your portfolio back to even.

^^Bf^ Stock mutual funds reduce your risk by investing in many stocks, often 50 or more. If a fund holds 50 stocks and one drops to zero, you lose only 2 percent of the value of the fund if the stock was an average holding. If the fund holds 100 stocks, you lose 1 percent, and a 200-stock fund loses only 0.5 percent if one stock goes. And don't forget another advantage of stock mutual funds: A good fund manager is more likely to sidestep investment disasters than you are.

Another way that stock funds reduce risk (and thus their volatility) is by investing in different types of stocks across various industries. Some funds also invest in U.S. and international stocks (even though the fund names may hide this fact).

Different types of stocks don't always move in tandem. So if smaller-company stocks are being beaten up, larger-company stocks may be faring better. If growth companies are sluggish, value companies may be in vogue. If U.S. stocks are in the tank, international ones may not be. (I discuss these different types of stocks later in this chapter.)

You can diversify into different types of stocks by purchasing several stock funds, each of which focuses on different types of stocks. There are two potential advantages to this diversification. First, not all of your money is riding in one stock fund and with one fund manager. Second, each of the different fund managers can focus on and track particular stock investing possibilities.

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