One of the main advantages of collective investment is the reduction in investment risk (capital risk) by diversification. An investment in a single equity may do well, but it may collapse for investment or other reasons (e.g., Marconi, Enron). If your money is invested in such a failed holding you could lose your capital. By investing in a range of equities (or
other securities) the capital risk is reduced.
- The more diversified your capital, the lower the capital risk.
This investment principle is often referred to as spreading risk.
Collective investments by their nature tend to invest in a range of individual securities. However, if the securities are
all in a similar type of asset class or market sector then there is a systematic risk that all the shares could be affected by adverse market changes. To avoid this systematic
risk investment managers may diversify into different non-perfectly-correlated asset classes. For example, investors might
hold their assets in equal parts in equities and fixed income securities.
Reduced dealing costs
If one investor were to buy a large number of direct investments, the amount they would be able to invest in each holding
is likely to be small. Dealing costs are normally based on the number and size of each transaction, therefore the overall
dealing costs would take a large chunk out of the capital (affecting future profits). Pooling money with that of other investors
gives the advantage of buying in bulk, making dealing costs an insignificant part of the investment.