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Why Funds That Can't Beat the Market Still Have a Function

Mutual funds shouldn't always think of beating the market. As a group, most of them can't (despite our preference for relative returns stated in an earlier blog). But they still have a useful function that they can perform in society.

Most investors have decided preferences, in regards to risks, as well as returns. Having postulated that money managers cannot control returns, we will try to redirect  their attention to something money managers can largely control, which is risk. .

Every stock and bond has a risk profile (as well as a return profile). Bonds have different profiles than stocks, in that a bond carries a money-back guarantee that is as good as the issuer. So the task in evaluating a bond should be determining whether or not it will be "money good" on the date of maturity. Interim "total return" considerations shouldn't matter. (And if they do, it is probably a sign that the bond portfolio is  "too long" for the investor.)

Some stocks have the exact opposite risk. The equity of a low-debt company like Microsoft or Oracle might not have much "default" risk, but it might have valuation risk; investors pay too much for it. That's why a Graham and Dodd investor prefers to buy stocks around "bond" value, basically around book value.
 

Other stocks are hybrids; suppliers of income, with some potential for capital gains. The issues of utilitiies  or REITs fall into this cateogry, but they have exposures tied to their particular industries. That's why Ben Graham preferred to own 50-100 stocks tied to 10 or 20 industries, creating a diversified portfolio.

Here you have three different types of portfolios of low, medium and high risk, based on high, medium or low income, for three different types of investors.

Mutual funds cannot promise to "beat the market" or even make money. What they can do is to identify their investors and to structure diversified portfolios of appropriate securites to match these investors' risk preferences.