Pooled Investments: Buying the Basket Instead of the Apple

What this means

Suppose you have $200 to invest. Buying individual stocks with $200 gets you shares in maybe one or two companies, and now your entire outcome depends on how those one or two companies do. That is a fragile position, and it is not a smart one at any dollar amount.

Pooled investmentsAn investment vehicle that pools money from many investors to buy a collection of assets that all the investors share. solve this. Thousands of investors contribute, the pool buys a large basket of stocks or bonds, and each investor owns a proportional slice of the entire basket. Your $200 can end up spread across hundreds of companies.

Two forms dominate. A mutual fundA pooled fund whose shares are bought from and sold back to the fund company at a price calculated once per day after the market closes. is priced once daily at its NAVNet asset value: the total value of everything the fund holds, divided by the number of shares outstanding., and you transact directly with the fund company. An exchange-traded fundExchange-traded fund: a pooled fund whose shares trade on a stock exchange throughout the day like a stock., or ETF, holds a basket the same way but its shares trade on an exchange all day at continuously changing prices. Same core idea, different plumbing.

The principle underneath is diversificationSpreading money across many different investments so that no single one can badly damage the whole., and it operates on two levels that students routinely collapse into one.

Diversifying within an asset classSpreading money across many different holdings of the same type, such as owning many companies' stocks. means owning many different stocks instead of a few. If one company collapses, it is one holding out of hundreds. This protects you from company-specific disasters: a fraud, a recall, a failed product, a lost lawsuit.

Diversifying across asset classesSpreading money across different types of assets, such as stocks, bonds, and real estate, which tend not to move together. means also owning things that are not stocks at all. Stocks and bonds often respond differently to the same economic news, so holding both softens the ride compared with holding only one.

Here is the limit, and it is important. Diversification eliminates the risk specific to individual holdings. It cannot eliminate the risk that hits everything at once. When a broad downturn arrives, owning five hundred companies does not save you, because all five hundred are exposed to the same economy. Diversification is protection against one thing going wrong, not against everything going wrong together.

Why it matters

Diversification is the closest thing investing has to a free improvement. Almost every other way to improve expected returns requires accepting more risk. Spreading out reduces one kind of risk without requiring you to give up expected return in exchange. That is unusual and it is why the idea is so heavily emphasized.

It also has a real cost that gets glossed over. Funds charge an expense ratioThe annual percentage of your money a fund charges to operate, deducted automatically from fund assets., deducted quietly from fund assets rather than billed to you. You will never see a charge on a statement, which makes it easy to ignore, and small annual percentages compound into large amounts over decades. Buying individual stocks avoids that ongoing fee, but requires you to research and monitor every holding yourself and makes real diversification expensive to achieve. Neither approach is free of trade-offs.

Try it

1. Build the concentration demonstration. Give each student an imaginary $1,000. Version A: put all of it into one company. Version B: split it evenly across ten companies. Version C: split it across a fund holding five hundred companies.
2. Now run a shock. One company in the portfolio loses 100 percent of its value. Calculate the dollar loss and the percentage loss for each of the three versions. Put the numbers side by side.
3. Run a second shock, this time a broad downturn where nearly everything falls 20 percent at once. Recalculate all three versions. Discuss what changed compared with step 2 and what did not.
4. State the conclusion in your own words. Write one sentence about what diversification protected you from in step 2, and one sentence about what it failed to protect you from in step 3.
5. Look up a real broad stock fund or ETF. Find how many holdings it contains, its top ten holdings, and its expense ratio. Record the date. Do not use any expense ratio from memory or from a textbook.
6. Look up a bond fund and do the same. Note what kinds of bonds it holds and roughly how long they run to maturity.
7. Build the trade-off table. Two columns, "Diversified fund" and "Individual stocks and bonds." Rows: cost, research effort required, control over exactly what you own, ability to diversify with a small amount of money, tax control, and chance of dramatically beating or dramatically trailing the overall market.
8. Argue it out. Assign half the class to defend the fund approach and half to defend individual holdings. Rule: nobody may name a specific fund or company as a recommendation. Argue mechanisms only.

Check yourself