Question

As an individual investor, you are attempting to invest in a well- diversified portfolio of mutual funds so that you will be somewhat insulated from any type of economic shock that may occur.
a. An investment adviser recommends that you buy four different U.S. growth stock funds. Since these funds contain over 400 different U.S. stocks, the adviser says that you will be well insulated from any economic shocks. Do you agree? Explain.

Answer 1

Answer with Explanation :

No, we are not agreeing with the adviser that investing in 400 different stocks can insulate the fund from economic shocks. This is due to the fact that

There are usually several types of risks that mutual funds can encounter :

1. Equity Risk is the risk that the decrease in the value of a stock, may erode the value of the fund

2. Inflation Risk is the risk that the currency is devalued i.e., inflation will erode the value of the dollar and reduce the value of long-term investments

3. Market Risk: This risk is associated with the overall market in general.

4. Currency Risk: The risk that a decline in the exchange rate will reduce your gains (or add to losses)

By investing in different stock funds with 400 different stocks, only the equity risk can be minimized, but the other type of risks such as inflation,market, and currency risk still exist. As a result the statement that one would be well insulated from economic shocks is false.