Section II - Lesson 5C
Investing Basics - Understanding Risk: Diversification
We stated, in the previous lesson, that time, diversification, and dollar cost averaging serve to minimize the risks of owning common stock to the point of non-existence. These three factors, in combination, form a powerful team to protect us from serious, permanent market damage. In the last lesson we discussed the impact of time. Let's turn our attention to diversification.
As long as we diversify, time will always bail us out. No matter how badly the stock market has ever been hit, it has always recovered, and always gone higher. Always! This is the healing power of time, but time may not be able to help us very much if we fail to diversify. If, however, we make sure to invest in the broadest possible cross section of the marketplace, we will always recover and go higher along with the general market.
By diversifying we avoid the risks of being in the wrong stocks at the wrong time. No individual stock or group of stocks will remain in favor perpetually. New ideas come and go and yesterday’s glamour stocks are pushed aside by the darlings of today. Yet the general market works inevitably higher as progress and technology make things better and more enjoyable for all of us.
We are fortunate to have an ideal mutual fund product available to us to provide this needed diversification, and I’m speaking of course about S&P 500 Index funds. A number of well-known mutual fund companies offer this product. The largest, and most popular of these funds is offered by the Vanguard Group, who pioneered the concept in the early 1970’s.
Vanguard’s 500 Index Fund is the world’s biggest mutual fund with over $91 billion in assets. The investments of the fund are the 500 stocks of the S&P 500 Index, represented in the same proportions as their weight in the index. This is a no-load, minimum fee mutual fund that seeks to duplicate the performance of the market index.
The Standard and Poor 500 Index itself is a composite that represents 70 percent of the value of all U.S. traded common stocks. Over any period of time this index has consistently outperformed the experts. Buying funds that are based on this index is a convenient, efficient, and inexpensive way to “buy the general market.”
Diversification protects us from experiencing lasting damage when events and circumstances change the course of the marketplace. It does not eliminate the fluctuations of the market, although it serves to make the swings less volatile than they might be for a single stock or single group or industry.
The really good news, for people like ourselves, is that we can expect to achieve an overall average annual rate of return of 10.5% or so, over the long term, from such a simple and convenient product, while enjoying the safety of broad diversification across the spectrum of America’s largest and most influential corporations.
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