Put money into investment funds reduces the risk, Always.
Let’s look at the types of risks involved in investing in an asset and why diversification helps.
Risk refers to the possibility that the actual return of an investment differs from its expected return. There are two types:
- Fluctuation of stocks return due to firm-specific news is unrelated across stocks and is therefore also called independent, unique or diversifiable risk.
- Fluctuation of stocks return due to market-wide news represent common risk. Since all stocks are affected simultaneously by the news, this type of risk is also called systematic, undiversifiable or market risk.
The risk premium for diversifiable risk is zero. Investors are not compensated for holding firm-specific risk. Diversification has no impact on systematic risk: Even a large portfolio will be affected by risk that affect the entire economy.
The risk premium of a security is determined only by its systematic risk and does not depend on diversifiable risk.
In finance there is an inherent law according to which those who risk more, then will earn more, but this does not apply to all risks.
If I invest in Apple, its price will vary based on news or earnings.
If I wanted to have the whole computer business, I would have to invest in Microsoft too, so when Macs sell less, they probably bought more Windows laptops.
But if the US economy is doing well (badly), they both gain (lose).
How to avoid risk specific
We should invest in both so that in a stable economic situation when one loses, the other gains and having both of them you are protected.
Remember our goal is not to make money, but as Warren Buffet says it’s not to lose money (after inflation).
What if the economy is bad?
Let’s say that there are sectors that respond well to crises. They are called defensive sectors. – Examples are: utilities, health care, and consumer staples
Instead the cyclical sectors go hand in hand with the economy. The economy is good, they get going, the economy is bad, they are affected.
– Examples are: automotive or technology
Investing in the whole economy (approximately), let’s say that the best companies in the best sectors are enough for us.
Investment funds allow us to diversify risk by investing for us following a predefined strategy at the cost of a fee.
Funds do not have to be based on shares. There are funds that invest in bonds, real estate, currencies, precious metals, anything else or a mix of all of these.
Typically Funds have separate assets from that of the companies that take care of their establishment, management, administration and marketing activities. Therefore, they are not exposed to the risk of default that occurs, for example, by directly purchasing bonds or equities.
There are 2 types of open and closed funds.
Open because they always accept new customers
Closed because the number of members of the fund cannot increase
Pension funds are typically open funds
There are other 2 characteristics to control them:
Actively: the fund manager is a great and will give you better returns, but fees are higher
Passively: the fund needs only some adjustment every month/ bimonthly/ quarter to stick with the strategy —-> low fees
And which one do we choose?
Of course, ETFs (I told you we’d talk about it)
ETFs are passively managed open funds, they are also widely traded on financial markets, differently from other types of funds.
- Low fees
- Stick with the strategy
- Wide diversification
- Are too many (I’m not joking)
For a complete guide on ETF I leave you to this one created by Mister Rip, it is useless to make another one would be a copy-paste of his excellent post.