The Diversification of Mutual Funds
A mutual fund has a definition of an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. Diversification attempts to eliminate unsystematic risk in the portfolio so that the positive performing investments neutralize the negative performing investments.
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Function
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Diversification has a definition of a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. This diversification will try to limit that amount of company-specific risk, also known as alpha risk.
Time Frame
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A prudent investor will still examine the time horizon of the invested funds. While a mutual fund offers diversification, a stock fund can still show losses to the principle investment in the short run. While a stock fund historically outperforms a stock-bond fund or a bond fund over a long period, this stock fund will likely have higher volatility in the short term. Short-term investors should research money-market funds or bond funds, and medium-term investors should research a stock-bond fund.
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Features
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Mutual funds provide access to investors to diversified portfolios, professional management and low management fees, which would otherwise create nearly insurmountable challenges for investors with small portfolios. The optimal portfolio should contain at least 25 to 30 stocks, and some say it should contain as many as 50 stocks. The commissions on these purchases and the size of the portfolio to purchase all these securities become prohibitive for the average investor.
Benefits
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Most individual investors have a smaller portfolio size and may find adequate diversification difficult. Purchasing shares of a mutual fund provides investors a more efficient way to diversify. This rationale alone explains why individual investors have made mutual funds popular. And as these mutual funds grow in size, they have the ability to continue to lower their management fees; also, most have break-points according to the size of the fund.
Considerations
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Investing in foreign securities can cause further diversification benefits, since these securities tend to have less correlation with the domestic markets. For example, the Chinese economy may show strength with a strong dollar as they export many goods to the United States, even though the U.S. economy may show signs of weakness. The investor should see strength in their Chinese or foreign stocks while their domestic stock would show moderation.
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References
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