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Understanding how to reduce risk by investing in collections of assets rather than single stocks.
If you bet all your savings on one company and it goes bankrupt, you lose everything. But what if you could own a tiny piece of 500 different companies at once for the price of a single pizza?
In the world of investing, diversification is often called the only 'free lunch.' This is the practice of spreading your money across many different investments to reduce risk. If you own only one stock, and that company fails, your investment goes to zero. However, if you own 100 different stocks, one company failing only impacts of your portfolio. This protects you from unsystematic risk—the danger associated with a specific company or industry. By 'pooling' money with other investors, you can gain access to a massive variety of assets that would be too expensive to buy individually.
Quick Check
If an investor puts all their money into a single tech company, what type of risk are they primarily exposed to?
Answer
Unsystematic risk (or single-stock risk).
A Mutual Fund is a financial vehicle made up of a pool of money collected from many investors. A professional fund manager uses that pool to buy a diversified portfolio of stocks, bonds, or other securities. When you buy a 'share' of a mutual fund, you own a proportional piece of every asset in that fund. The value of one share is known as the Net Asset Value (NAV). Unlike stocks, mutual funds only trade once per day after the market closes, meaning everyone buying that day gets the exact same price.
To find the price of a mutual fund share, we use the NAV formula:
1. Total Assets: The fund owns stocks worth $\$10,000,000\ in fees.
3. Shares Outstanding: There are shares held by investors.
$\$19.00$ per share.An Exchange Traded Fund (ETF) is very similar to a mutual fund because it holds a basket of assets. However, as the name suggests, it is traded on an exchange just like an individual stock. This means the price fluctuates throughout the day, and you can buy or sell it at any time during market hours. ETFs are often praised for their tax efficiency and lower expense ratios (the annual fee you pay to the fund) compared to traditional mutual funds.
Quick Check
What is the main difference between how a Mutual Fund and an ETF are traded?
Answer
Mutual funds trade once per day after the market closes, while ETFs trade throughout the day on an exchange like a stock.
Investors must choose a strategy: Active Management or Passive Indexing. Active managers try to 'beat the market' by picking specific stocks they think will outperform. This requires a lot of research, leading to higher fees. Passive Indexing, on the other hand, simply tries to match the market by tracking an index like the S&P 500. Because there is no expensive team of researchers, passive funds usually have much lower fees. Historically, most active managers fail to beat passive index funds over long periods of time.
Imagine you invest $\$10,0007\%\.
2. Active Fund (1.50% fee): Your final balance would be approximately $\$49,800$.
Even though the return was the same, the higher fee cost you over $\$25,000$ in potential wealth due to the loss of compounding interest on the money paid in fees.
Which term describes the strategy of 'not putting all your eggs in one basket'?
If a fund's goal is to exactly match the performance of the S&P 500, what is it called?
ETFs can be bought and sold at any time during the trading day.
Review Tomorrow
In 24 hours, try to explain the difference between 'Active' and 'Passive' investing to a friend without looking at your notes.
Practice Activity
Go to a financial website (like Yahoo Finance) and look up the ticker 'SPY'. Identify its expense ratio and see how many companies it holds.