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Mutual funds, a type of investment where the money from multiple investors is invested together in several stocks, offer advantages over individual stocks, including diversification and convenience.

Reducing Risk With Diversification

Investing in only a handful of stocks is risky because the investor's portfolio is severely affected when one of those stocks declines in price. Mutual funds mitigate this risk by holding a large number of stocks; when the value of a single stock drops, it has a smaller effect on the value of the diversified portfolio.

For example, suppose a person owns 10 shares each of two stocks, with each share valued at $100. If the price of one of the stocks falls by 25%, the value of the portfolio declines from $2,000 to $1,750, a drop of 12.5%. If, instead, the portfolio consists of one share each of 20 stocks, each valued at $100, then a decline of 25% in the price of one stock brings the value of the portfolio from $2,000 to $1,975. This is a decline of only 1.25% in the value of the overall portfolio.

Mutual Funds Offer Convenience

In addition, investing in mutual funds is more convenient than investing in individual stocks because the manager of the fund researches stocks and decides which ones to purchase. An investor buying individual stocks has to make these decisions for himself. However, the downside of this convenience is the fee a mutual fund manager charges, which reduces the amount investors can earn from the fund.

While mutual funds are diversified and convenient, whether investing in them is an ideal way to maximize returns is a matter of debate among economists. Those who support the efficient market hypothesis (EMH) believe investors who buy individual stocks are generally unable to achieve returns as high as the returns of the market as a whole. Thus, they recommend people invest in index funds, which are mutual funds that track a market index and generally have low expense ratios. Other economists dispute this hypothesis and argue that buying individual stocks has the potential for higher returns than mutual funds.

(For related reading, see "Mutual Funds Basics Tutorial.")

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