Many experts agree that almost all of the advantages of stock portfolio diversification (the benefits derived from buying a number of different stocks of companies operating in dissimilar sectors) are fully realized when a portfolio holds around 20 stocks. At the point that a portfolio holds 20 stocks from 20 companies operating in different industries, almost all of the diversifiable risk associated with investing has been diversified away. The remaining risk is deemed to be systematic risk, or market-wide risk, which cannot be diversified away. Since most brokerage firms having a minimum share purchase requirement, it's hard for many investors to afford 20 different stocks.
A brokerage firm that imposes a minimum share buy of 100 shares requires investors to buy 100 shares of each stock they wish to purchase. If the average price of a share is $20, then investors buying through that brokerage firm are required to invest a minimum of $40,000 ($20/share*100 shares*20 different stocks). Most investors just don't have $40,000 sitting around to invest, so mutual funds allow investors to get the maximum benefits of diversification without having to meet any minimum required share purchases.
The convenience of mutual funds is undeniable and is surely one of the main reasons investors choose them to provide the equity portion of their portfolio, rather than buying individual shares themselves. Determining a portfolio's asset allocation, researching individual stocks to find companies well positioned for growth as well as keeping an eye on the markets is all very time consuming. People devote entire careers to the stock market, and many still end up losing on their investments. Though investing in a mutual fund is certainly no guarantee that your investments will increase in value over time, it's a way to avoid some of the complicated decision-making involved in investing in stocks.
Many mutual funds like a sector fund offer investors the chance to buy into a specific industry, or buy stocks with a specific growth strategy such as aggressive growth fund, or value investing in a value fund. People find that buying a few shares of a mutual fund that meets their basic investment criteria easier than finding out what the companies the fund invests in actually do, and if they are good quality investments. They'd prefer to leave the research and decision-making up to someone else.
Finally, the trading costs of buying and selling stocks are often prohibitively high for individual investors. So high-priced in fact, that gains made from the stock's price appreciation can easily be canceled out by the costs of completing a single sale of an investor's shares of a given company. With a mutual fund, the cost of trades are spread over all investors in the fund, thereby lowering the cost per individual. Many brokerage firms make their money off of these trading costs, and the brokers working for them are encouraged to trade their clients' shares on a regular basis. Though the advice given by a broker may help clients make wise investment decisions, many investors find that the financial benefit of having a broker just doesn't justify the costs.
It's important to remember there's disadvantages of mutual fund investment as well, so as with any decision, educating yourself and learning about the bulk of available options is the best way to proceed.
Joe Allaria, CFP®
CarsonAllaria Wealth Management, Carbon, IL
A mutual fund will provide diversification through the exposure to a multitude of stocks. The reason that is recommended over owning a single stock is that owning an individual stock would carry more risk than a mutual fund. This type of risk is known as unsystematic risk. Unsystematic risk is risk that can be diversified against. For example, by owning just one stock, you would be carrying company risk that may not apply to other companies in the same sector of the market. What if their CEO and executive team leaves unexpectedly? What if a natural disaster hits a manufacturing center slowing down production? What if earnings are down because of a defect in a product or a lawsuit? These are just a few examples of the types of things that could happen to one company, but are not likely to happen to all companies at once.
Yes, there is also systematic risk, which is risk that you cannot diversify against. This would be similar to market risk or volatility risk. It should be understood that there is risk associated with investing in the market. If the market as a whole declines in value, that is not something that can easily be diversified against.
Therefore, if you'd like to invest in individual stocks, I would recommend researching how you can compile your own basket of stocks so that you don't own just one stock. Make sure you are sufficiently diversified between large and small companies, value and growth companies, domestic and international companies, and also between stocks and bonds, according to your risk tolerance. This is where it might be helpful to seek out professional help when constructing these types of portfolios. This type of research and portfolio construction and monitoring can take quite some time.
The alternative is to invest in a mutual fund for instant diversification... of course, there are a list of things to be aware of when choosing mutual funds as well. Fees, investment philosophy, loads, and performance are just a few components to consider when evaluating mutual funds.