17.2 How households supply financial capital  (Page 7/43)

The overall pattern is that stocks as a group have provided a high rate of return over extended periods of time, but this return comes with risks. The market value of individual companies can rise and fall substantially, both over short time periods and over the long run. During extended periods of time like the 1970s or the first decade of the 2000s, the overall return on the stock market can be quite modest. The stock market can sometimes fall sharply, as it did in 2008.

The bottom line on investing in stocks is that the rate of return over time will be high, but the risks are also high, especially in the short run; liquidity is also high since stock in publicly held companies can be readily sold for spendable money.

Mutual funds

Buying stocks or bonds issued by a single company is always somewhat risky. An individual firm may find itself buffeted by unfavorable supply and demand conditions or hurt by unlucky or unwise managerial decisions. Thus, a standard recommendation from financial investors is diversification    , which means buying stocks or bonds from a wide range of companies. A saver who diversifies is following the old proverb: “Don’t put all your eggs in one basket.” In any broad group of companies, some firms will do better than expected and some will do worse—but the extremes have a tendency to cancel out extreme increases and decreases in value.

Purchasing a diversified group of the stocks or bonds has gotten easier in the Internet age, but it remains something of a task. To simplify the process, companies offer mutual funds    , which are organizations that buy a range of stocks or bonds from different companies. The financial investor buys shares of the mutual fund, and then receives a return based on how the fund as a whole performs. In 2012, according to the Investment Company Factbook, about 44% of U.S. households had a financial investment in a mutual fund—including many people who have their retirement savings or pension money invested in this way.

Mutual funds can be focused in certain areas: one mutual fund might invest only in stocks of companies based in Indonesia, or only in bonds issued by large manufacturing companies, or only in stock of biotechnology companies. At the other end of the spectrum, a mutual fund might be quite broad; at the extreme, some mutual funds own a tiny share of every firm in the stock market, and thus the value of the mutual fund will fluctuate with the average of the overall stock market. A mutual fund that seeks only to mimic the overall performance of the market is called an index fund    .

Diversification can offset some of the risks of individual stocks rising or falling. Even investors who buy an indexed mutual fund designed to mimic some measure of the broad stock market, like the Standard&Poor’s 500, had better buckle their seatbelts against some ups and downs, like those the stock market experienced in the first decade of the 2000s. In 2008 average U.S. stock funds declined 38%, reducing the wealth of individuals and households. This steep drop in value hit hardest those who were close to retirement and were counting on their stock funds to supplement retirement income.