One of the most widely recognized investing principles is portfolio diversification. Surprisingly, novice and seasoned investors alike often misinterpret the true meaning of diversification. A common misconception is that diversification means no more than investing in many different companies. Subscribers to this fallacy may fill their portfolio with high profile glamour stocks, for example, that appear in the headlines day after day. Akin to a collection of unrelated shiny objects, these investments typically offer few of the benefits of diversification. A well-diversified portfolio bears little resemblance to a random collection of shiny objects.
When an investor opens their portfolio statement, they may see both traditional mutual funds and exchange traded funds (ETFs) in their portfolio. These are common investment vehicles, yet few investors understand the differences between the two, or how a professional money manager can help them navigate the intricacies of fund options.
The similarities of the two fund types are easy: both are baskets of stocks, bonds, or other assets – and they allow investors a relatively inexpensive way to diversify their portfolios. The differences appear in how the two types of funds trade, and the breadth of their respective holdings.
Mutual funds are the elder of the two types of funds, having been around since the 18th century. Partially because these funds have been around longer, there’s a good chance an investor can find a mutual fund with at least some coverage of the market area she/she wants to invest in. For more popular investments (e.g. technology), there are many mutual funds that hold similar assets. An added nuance of mutual funds is that they only trade once per day, at the end of the trading session – regardless of what time investors hit the “buy” button! This might not sound like a big deal, but it’s akin to committing to the purchase before you know the price…not an ideal situation for any investor.