Several of my friends have taken pity on me. They know that I have been an advocate of mutual fund investing for more than 25 years and that I have been writing a mutual fund investment advisory letter for more than 15 years. "What a shame," they tell me. "Spending all those years pushing an investment vehicle that doesn’t produce very good results."

These "friends" have been investing in individual stocks for a couple of years, and they claim that they have been beating the pants off mutual fund investors. I’ve tried to tell them about the benefits of diversification and the risk reduction that it provides. However, they point out to me the disappointing returns provided by diversified mutual fund portfolios in recent years.

"Buy a handful of stocks of great companies," they say, "and you are guaranteed big long-term returns. Diversify, and you accept mediocrity."

I have quit arguing with my know-it-all investor friends. Certainly the data supports their argument. For example, the Standard & Poor's 500 Index has beaten the returns of 93 percent of all mutual funds the last 10 years and 97 percent over the last five.

On average, the typical equity mutual fund hasn’t come close to keeping pace with the unmanaged S&P 500 Index in recent years.

If you were diversified across a number of equity funds with varying investment objectives during the last five years, your portfolio’s returns were most likely well below that of the S&P 500 Index. If you sent some of your money to international equity funds, your portfolio’s performance was poorest of all.

Why even invest in the S&P 500 Index? That index returned 32.4 percent during the last 12 months. However, if you invested in the stocks of the 10 largest companies in the index (General Electric, Microsoft, Exxon, Coca-Cola, Merck, Wal-Mart, Intel, Pfizer, IBM and Philip Morris), you would have earned more than 52 percent.

Had you invested in just the five largest stocks in the Nasdaq Index (Microsoft, Intel, MCI WorldCom, Dell and Cisco), your return would have exceeded 156 percent. If you had owned the stock of only one company, Dell Computer, your return last year would have topped 235 percent. The lesson in these statistics is: "The less you own, the more you get."

In truth, however, the last three years have been quite unique. Except for the late 1960s, when the "nifty 50" was a popular investment strategy, there has never before been a period in history during which the stocks of such a small number of companies has delivered exceptional returns, year after year.

Even more amazing is the fact that the best performance in recent years has been reserved for the stocks of America’s largest companies. And given that the S&P 500 Index is a market-weighted index, the performance of the index has largely been dictated by the performance of a handful of stocks. In other words, indexes such as the S&P 500 Index, the Dow Jones Industrial Average and even the Nasdaq Composite Index (of more than 5,600 stocks) have been giving a false impression of what the stock market has returned in recent years.

Furthermore, it’s not what you have earned lately that counts. It’s what you earn over a lifetime of investing. Anyone can earn exceptionally large returns for a couple of years. Just invest in a handful of stocks and hope that luck is on your side.

However, over the long run, investment returns are tied to investment risks. Portfolios containing a only handful of stocks are very risky. Eventually, stock price down-drafts tend to cause returns to return to the level dictated by their risk. In other words, non-diversified investors will eventually see the risk in their folly. However, when that risk becomes apparent, their investment capital will have all but disappeared.

Aesop once wrote, "Slow and steady wins the race." The same can be said of the results of a lifetime investment strategy. Diversify, remove the fits and s tarts in your portfolio’s performance and you too can win the investment marathon. And the best way to diversify is to invest in well-managed mutual funds.

 

 

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