James d. Gwartney

Mutual funds
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and exchange-traded funds (ETFs) can help investors diversify and
reduce risk. Mutual funds and ETFs simply combine the funds of a group of investors and
channel them into various categories of investments, such as stocks (equities
(?)
), bonds, real
estate, or treasury bills
(?)
. Thus, there are a variety of mutual fund categories.
An equity mutual fund
(?)
channels the funds of its investors into the stock of many
firms. These funds provide even small investors with an economical way to achieve diversity
and reduce risk. The risks of stock market investments are substantially lowered if you
continually add to or hold a diverse portfolio of stocks over a lengthy period of time, say thirty
or thirty-five years. Historically, when a diverse set of stocks has been held over a lengthy time
frame, the rate of return has been high and the variation in that return has been relatively small.

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Regular payments into an equity mutual fund holding a diverse set of stocks provide investors
with a low-cost method of investing in the stock market.
Diversification will reduce the volatility of investments in the stock market in two
ways. First, when some firms do poorly, others do well. An oil price decline that causes lower
profits in the oil industry will tend to boost profits in the airline industry because the cost of
airline fuel will decline. When profits in the steel industry fall because steel prices decline, the
lower steel prices will tend to boost the profits in the automobile industry.
Second, diversification can help protect you against a change in general economic
conditions. A recession or an expansion will cause changes in the value of the stocks of almost
all firms. But diversification reduces the volatility in the value of your investments because a
recession is worse for some firms and industries than others, and a boom is better for some
than for others. For example, the recession that harms Max Mara (a high-fashion brand sold
worldwide) may boost sales and profits for Zara (a lower-priced competitor). Similarly,
recessions may improve the relative position of Skodas relative to BMWs.
Some employers offer retirement programs that will match your purchases of the
company stock (but not investments in other firms) or will allow you to purchase the company
stock at a substantial discount. Such a plan makes purchasing the stock of your company
attractive. If you have substantial confidence in the company, you may want to take advantage
of this offer. After a holding period, typically three years, these plans will permit you to sell the
purchased shares and use the proceeds to undertake other investments. As soon as you are
permitted to do so, you should choose this option. Failure to do so will mean that you will soon
have too many of your investment eggs in the basket of the company for which you work. This
places you in a position of double jeopardy: Both your employment and the value of your
investments depend substantially on the success of your employer. Do not put yourself in this
position.
Your job may offer you a general pension fund that is required by the government.
These funds can have different investments depending on where you work. It is important to be
aware of what your company pension fund is invested in, and to make sure your own personal
investments diversify away from the pension fund’s holdings.
(110)
We can summarize the importance of stock investments and diversity this way: To

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achieve their financial potential, individuals must channel their savings into diversified
investments that yield attractive returns. In the past, long-term investments in the stock market
have yielded high returns. Equity mutual funds make it possible for even small investors to
hold a diverse portfolio, add to it monthly, and still keep transaction costs low. Investing in a
diverse portfolio over a lengthy period of time reduces the risk of stock ownership to a low
level. All investments have some uncertainty. But if the past century and a half are any guide,
we can confidently expect that over the long haul, a diverse portfolio of corporate stocks will
yield a higher real return than will savings accounts, bonds, certificates of deposit
(?)
, money
market funds, and similar financial instruments. Ownership of stock through mutual funds is