Let’s say you own a stock, and over a 3-month period, the share price declines by 40%. What do you do?
Some people would say to hold onto it in order to avoid “selling low,” but that ignores the possibility that the stock may have declined precipitously for a good reason. It may well be the case that the company is in serious trouble, and it’s facing a real possibility of going out of business. If that’s the case, it’s potentially a good idea to get rid of any shares that you own–no matter how little you get for them.
To put it differently: With individual stocks, there is a very significant amount of long-term risk. With any given stock, there is no guarantee that you’re going to earn money, even if you have the patience to own it for 30 years. (In fact, as we discussed last week, there’s a substantial chance that you could lose all of your money.)
Mutual funds work differently.
Well-diversified mutual funds (index funds being the most obvious example) are not subject to the same type of long-term risk.
Let’s say you own an index fund that tracks the Wilshire 5000 (which represents basically the entire U.S. stock market). If it declines 40% in value over three months, it’s fairly safe to say that it didn’t happen because the entire U.S. economy is about to “go out of business.” Therefore, if you hold onto your fund, you can be confident that you’re going to (eventually) make money.
This lack of long-term risk is a big difference between mutual funds and individual stocks. And that seems obvious. It’s the very foundation of the concept of diversification.
So why do people treat mutual funds like stocks?
What’s so I find fascinating (and unfortunate) is the fact that many people seem to deal with mutual funds like they do with stocks. They see a 40% decline in share value, and they go running, seemingly unaware of the fact that if they’d just hold on, they’d eventually turn a profit.
I wonder if this is partially due to the fact that stocks have been around for much longer than mutual funds. Perhaps there are certain facts about stocks–things like “Stocks are risky” and “If a stock price drops, it could mean there’s a problem.”–that have reached a point where essentially everybody in our culture knows them.
In contrast, a real understanding of mutual funds has not yet reached that level of collective awareness in our culture. Instead, we make due with what we have. We (mistakenly) apply our knowledge of stocks to the behavior of mutual funds, assuming that we should deal with funds in the same way that we’d deal with the stocks of which they’re composed. Seems rational at first glance, but what unfortunate consequences!
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It probably has to do with people not knowing the theoretical difference between individual common stocks and index funds…and by most, it’s probably the vast majority.