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.