One issue for the small investor is getting sufficient diversification. Diversification is the spreading out of your money over a lot of different companies so that the issues at one company don’t cause a lot of damage to your total portfolio value. For example, if you put all of your money into two stocks and one of the stocks missed earnings by a wide margin, you might see your account balance drop by 25% as the price of the stock for the company that missed earnings fell by 50% over the course of the next week or two. There are also companies that suddenly implode due to missing industry trend, fraud by the officers, or the loss of a lawsuit. As in the case of TransOcean and BP, sometimes they drill a hole in the bottom of the ocean and kill everything in the vicinity. In that case, even other deepwater drilling operators that weren’t even involved such as Diamond Offshore took a big hit on their share price.
Diversification will not protect you from corrections in the entire market. For example, in 2008 if you owned only equities you were going to see the value of your portfolio decline by 20-40%. But then if you held on and didn’t sell you would see that portfolio value return within the next year or two. If you were diversified out of equities by holding bonds, you would also not have seen as big a decline since bonds held up a lot better than stocks.
The issue with diversifying when you only have $10,000 or so is that you can only buy a few individual stocks before the cost of buying the shares starts to really start to affect your returns. Typically you would want to buy at least 100 shares of each company to keep costs down, so if the stocks you were buying were in the $30 range you would only hold about three different stocks. This is not necessarily a terrible thing since you are only risking a loss of $3000 or so should one of your stocks go bankrupt outright, and you have the opportunity of making a much bigger return when you are concentrated in a few companies than if you are well diversified. Still, if you are not good at picking stocks, you might sit with three losers while the rest of the markets soar to new heights.
Mutual funds make it much easier to diversify. In a mutual fund, individuals pool their money together to buy a basket of stocks or other assets. They then get any dividends or interest paid by their investments, as well as any capital gains from sale of securities inside the mutual fund, divided up based on the percentage of the basket owned. For example, if three people pitched in $100 each and a fourth person pitched in $200 and the mutual fund made $100 from the sale of stock, the first three people would be entitled to $20 each and the fourth person would be entitled to $40 in a capital gains distribution. Normally the gains are reinvested back into the mutual fund, but taxes may still be due on the gain. (Warning, if you are holding some funds in a non-retirement account that trade a lot , take a look at the history of their capital gains distributions and be ready to pay about 20% of that amount in taxes each year. This can be done by selling some of the shares of the mutual fund or saving up other earnings.)
Buying into a mutual fund is fairly simple. Just go to the website of the fund company, fill out some forms, and then send in a check or make a deposit electronically. You can also setup automated drafts from your checking or savings account to make regular deposits. All funds have some minimum required investment to get started. After that, you can send in whatever amount you wish to purchase more shares. Not also that some funds allow you to start with a lower initial investment if you setup direct deposit for future investments.
When you buy into an open-ended mutual fund – the type offered by the fund companies – the price you pay per share will be based on the value of the stocks and other assets they hold in the fund, plus any cash they have. If the value of those assets increases, the price per share will also increase. For example, if a mutual fund holds 100 stocks worth $20 M, and then those stocks go up in price until the value of the stocks is $40 M, the price per share of the mutual fund will double. This means that someone buying into the fund then would need to pay twice as much per share. For practical purposes, however, this really doesn’t matter because you can buy any number of shares desired, even if it is 1.423 shares, for example. To you it will be sending in specific amounts of cash and then seeing the value of your position increase or decrease as the value of the portfolio the fund company holds changes in value.
Note also that in an open-ended fund, others buying in do not affect the value of your position. For example, looking back at our last example where four invesors put in $500, let’s say that the fund company used that money to invest in shares of stock. If a fifth investor then came along an invested $100, he would get a one-sixth share of the assets in the mutual fund (he invested $100 out of the $600 in the mutual fund, so he would own 1/6th of the mutual fund), but the mutual fund would also now have $100 more in cash to invest, so the other investors would not see their share price decrease. In other words, their share of the pie would decrease but the size of the pie would get bigger by the same amount.
In part two, I’ll talk about specific mutual fund portfolios that could be built to meet different investment needs and explain how to build-up such portfolios.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.