Congratulations, Sharon, you seem to be doing what is necessary to save for retirement and educate your children. It's not often that we come across folks who want to do more beyond the retirement and education goals.
After doing an excellent job of saving for retirement and funding the children's college education through monthly cash flow, Sharon is ready to take her investments to a new level. However, she does not know whether to invest in individual stocks or mutual funds.
To solve her dilemma, it's useful to start with an understanding of risk, specifically the risks associated with investing.
Total investment risk can be divided into two parts — systematic risk and unsystematic risk. Let's look at each in turn:
Economic, political and social changes produce systematic risk, which has four components:
Interest-rate risk, caused by fluctuations in general interest rates.
Reinvestment risk, caused when market interest rates decline and investors are forced to reinvest at lower interest rates.
Purchasing power risk, which refers to the impact of changes in price levels within the economy. It's the impact of inflation or deflation on an investment.
Market risk, which is the loss or gain of capital resulting from changes in the price level of investments. It's caused by investor reaction to tangible and intangible events.
Systematic risk is sometimes known as market risk.
Diversify, Diversify, Diversify
Unsystematic risk is associated with an individual business and represents that portion of the investment risk that can be reduced through diversification. It is unique to a company, industry or property. It has three components:
Business risk, which is associated with the enterprise itself.
Financial risk, associated with the mix of debt and equity used to finance the enterprise.
Exchange rate risk, associated with loss of principal due to the volatility of foreign currency values for companies doing business overseas.
In defining unsystematic risk, the emphasis is on diversification. Diversification among industries and industry sectors is the tool used to minimize such risk.
To properly diversify a portfolio among the various industry groups and sectors would require Sharon or anyone else to purchase at least 30 individual stocks, more realistically shares in 50 or more companies. For investors with less than a $1 million portfolio this can be expensive and very time consuming.
Most people have neither the time nor the skills to properly research and track 50 stocks. You can see from this logic that I'm suggesting that Sharon use mutual funds to build her portfolio.
Spread the Wealth
A well-run and highly diversified mutual fund will provide her with the ability to control the unsystematic risk in her portfolio. Additionally, the mutual fund's analysts will research and monitor stock selections for her.
Sharon can minimize systematic risk via careful asset allocation. This works because the classes of assets — stocks, bonds and cash — do not usually move in the same direction in unison.