Why Mutual Funds Make Sense in a Volatile Market

Violent swings may be here to stay, which makes investing in individual stocks risky.

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Seemingly every day, world stock markets swing wildly. One day, the Dow Jones Industrial Average drops 300 points over concerns over the European economic crisis. A few days later, the Dow rebounds on a better-than-expected job report. It was once believed that long-term investment in stocks was as close as one could get to a sure thing, as prices consistently rose over time. Now, the only thing that's predictable about the stock market is its unpredictability.

This uncertainty has made many investors nervous. Owning the wrong stock on the wrong day could be disastrous to long-term financial planning. Even if the stock recovers its value over time, the psychological impact of heavy losses over a short period can sour investors on stocks. Even bond markets, which for years have been considered a safe place to invest, are volatile. And simply keeping money in a savings account does not yield significant value over time.

[See 5 Ways to Measure Investment Risk.]

Given the current state of the economy, violent swings in the markets are unlikely to stop any time soon. Some economists argue that these big swings are the "new normal." Therefore, investing in just a handful of instruments is risky. The best strategy for investing is diversification. And if you're looking to diversify, mutual funds might be your best bet.

Spreading the risk. Simply put, mutual funds are collective investment instruments that bring together money to buy stocks, bonds, and money-market funds. They are professionally managed by firms like Fidelity and Franklin Templeton Investments, which take a percentage of the investment as a commission (this percentage varies from manager to manager). For the average investor who doesn't have the time or expertise to continually monitor the markets, this professional management is well worth this cost.

[See the 50 Best Funds for the Everyday Investor.]

Funds are comprised of a host of different instruments, depending on the management goal of the fund. For instance, an aggressive mutual fund is made up of stocks that carry more risk. A fund that aims to create long-term value invests in companies that have consistent earnings over time. Investors looking for a safety can invest in bond funds that produce lower but consistent returns.

The diverse composition of these funds is their most attractive quality. Exposure is spread across a number of instruments. One stock in a fund could go down dramatically one day. But other stocks in the fund, which would perform differently, would lessen the pain from this loss.

What also makes funds an attractive investment is the wide range of investing strategies available. There are funds to suit all tastes. A young investor can find a fund that's a bit more aggressive with its investment strategy. Older investors, who are looking for stability of returns can find funds that emphasize consistent performance and value. Investors looking for a safe place to park their money can invest in bond funds.

[See 4 Things You Should Know About Market Volatility.]

With any investment comes risk. That's not to say that there isn't risk in investing in mutual funds. These instruments only spread risk; they do not completely eliminate it. If the market is performing badly, the holdings of a fund will likely also perform poorly. While losses might not be as dramatic as an investment in an individual stock, they would still occur.

Another risk is that a fund could be too exposed to one region or industry. For example, many mutual funds invest in emerging markets. If something negative were to happen in this market—such as political unrest in Eastern Europe or a conflict in the Middle East—these funds would suffer badly.

Another disadvantage of mutual funds are fees. While many firms charge modesty fees, they vary and can quickly add up. Annual operating fees can be as high as 3 percent of the overall investment. If a fund has a bad year, this fee might seem unwarranted.