Why you should stick to Mutual Funds in today’s markets

As the economy begins to pick up, more and more people begin to consider equities to get a higher return on their money. After knowing today that stock values have trended upwards with significant gains after they hit rock bottom about a little more than a year ago with the credit crunch, many people constantly say they should have purchased stocks. The truth is, no one could have predicted the now apparent upward trend, or the price floor, and even a close estimate of the time frame for the equities to rebound.

The truth is that the average investor would not bare the risk of putting all of their eggs in to one basket, like purchasing Apple (NASDAQ:AAPL) shares in July 2009 when they were trading at only $135 per share (though clearly a discount, still expensive), compared to $230 as at March 27, 2010. But that doesn’t mean the small investor can’t benefit from the hot equities market today, they could, by considering mutual funds.

Mutual funds provide many benefits that are often over looked, misunderstood, or not even really known by the average investor.

There are two types of risks in purchasing stock, systematic risk and unsystematic risk. Systematic risk is simply the market risk, whereas unsystematic risk is firm specific risk. By having a small portfolio of less than 15 stocks, you are exposed to significant amounts of unsystematic risk. The market does not provide a risk premium for unsystematic risk because it can be diversified away. By adding about 30 stocks to your portfolio, much of the unsystematic risk disappears; adding more stocks only marginally reduces unsystematic risk, but usually about 30 stocks in a portfolio provides sufficient diversification to serve as a hedge to unsystematic risk. Since mutual funds are invested in many securities (often hundreds of stocks), you gain the added benefit of instant diversification, and optimal asset allocation, which instantly diversifies away unsystematic risk.

Another added benefit of mutual funds related to diversification is that many funds are invested in international securities, providing the added benefit of letting the average investor access markets that are otherwise not accessible due to high transaction and information costs (the mutual fund would also allow the investor to circumvent legal and institution barriers). Additionally, some securities such as commercial paper (securities issued by the most credit worthy firms such as IBM and are relatively not very risky) are only sold in large denominations such as in excess of $100,000; investing in a mutual fund allows the average investor to access those securities.

The average investor usually doesn’t have enough resources (capital) to hold so many positions, and if they did, they would continuously have to monitor the portfolio for margin calls (the requirement to add additional capital if positions lose value), and would have to consistently monitor the operations, industries, and markets of the invested firms. A mutual fund does all of that for you, along with expert portfolio managers that use highly complicated statistical models to make more informed decisions that usually lead to better returns. For example, Fidelity Investments in December 2008 re-opened its Contrafund mutual fund when it determined equities were deeply undervalued during the financial crisis.

Mutual funds also have economies of scale. Because of the massive pool of capital available and invested, and the large number of transactions made, mutual funds pay less for commissions and transaction costs. If you were holding 30 stocks and often made adjustments to your positions, transaction costs could become a material cost, whereas you wouldn’t have to worry about that with a mutual fund.

Remember when you are choosing a fund to buy into; you should consider whether it is industry or sector specific, that way you can ensure diversification. For example, if a fund were exclusively invested in airline stocks, a longer-term price decline of crude would hurt the fund as the stock values would decline hence your return would also decline. Sometimes, you must invest in more than one fund, depending on your position as to where the market is heading and to ensure diversification. However, many funds (“hybrid mutual funds”) have sufficient diversification since they hold many diverse securities such as risk-free treasury bills (T-bills), bonds, commercial paper, money market securities, international assets, are invested in multiple industries, among other less risky securities. In addition, you should consider a mutual fund that is non-loaded, has low fees, and just choose a fund that fits your investment horizon, and always read the prospectus.