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I'm trying to undertand deversification in mutual funds, specially in contrast with having your own stocks.

Mutual funds and ETFs that track some index (S&P, DJIA...) are diversified by definition.

Still, if you invest in one of the above, you don't own the actual stocks, so you are actually investing all your money in just one asset (index fund/ ETF). If something happens to the mutual fund and it crashes, you lose everything.

Is the above correct?

Does it make sense to invest in different index funds that track the same index, as a security measure?

  • Index ETF can fall sharply but they can never go bankrupt. – mootmoot Sep 26 at 13:06
  • @mootmoot what prevents an Index ETF not going bankrupt – Raj Sep 26 at 13:34
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    A traditional ETF cannot go bankrupt. It's assets are worth whatever the components are worth on the market. Exchange traded securities can become insolvent (see the VelocityShares Daily Inverse VIX Short Term ETN (XIV) which lost 96.3% of its value in one day and was closed). Leveraged ETFs (margin) can disappear but that's a function of market risk not fraud or broker failure. – Bob Baerker Sep 26 at 15:14
  • @Raj All trade activities of index fund ETF is well observed by the market, so Madoff alike scheme can be detected easily. Index ETF can also arrange and put those stock bought under a trustee account. So even if the broker bankrupt, stock inside the ETF trustee will be left unscratched. However, this does not apply to leverage ETF. – mootmoot Sep 27 at 7:22
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If something happens to the mutual fund and it crashes, you lose everything.

Nothing will happen to the mutual fund that doesn't also happen to the underlying index.

What might happen is that the brokerage goes bankrupt or collapses due to some malfeasance.

The SIPC should pick up the pieces after you, but that will take time. Better to just invest with large, time-tested brokerages without a history of shenanigans.

  • [...]collapses due to some malfeasance. Yes, that's exactly what I meant. – Martel Sep 26 at 13:42
  • @ronjohn SIPC will not help if the ETF /mutual fund is not buying the underlying money.stackexchange.com/questions/105424 – Raj Sep 26 at 13:44
  • @Raj A public ETF broker is making money in the simplest way and trade of securities is pretty transparent for auditing. While in Madkoff ponzi scheme, securities filing and auditing is virtually non-existent. – mootmoot Sep 26 at 15:01
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    I think that there are several issues being conflated here. If there's an error on the part of the broker, they carry errors and omissions insurance. One can also go to arbitration via FINRA. SIPC covers unauthorized trading in and theft from securities accounts. SIPC covers $250k of cash and $250k of securities should the broker go bankrupt. – Bob Baerker Sep 26 at 15:08
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Read JL Collins stock series. Part 10 provides a good explanation of why a large regulated brokerage that tracks an index can't crash.

"1. You are not investing in Vanguard, you are investing in one or more of the mutual funds it manages.

  1. The Vanguard mutual funds are held as separate entities. Their assets are separate from Vanguard, they each carry their own fraud insurance bonds, each has its own board of directors charged with keeping an eye on things. In a very real sense, each is a separate company operated independently but under the umbrella of Vanguard.

  2. No one at Vanguard has access to your money and therefore no one at Vanguard can make off with it.

  3. Vanguard is regulated by the SEC."

"But, if you are expecting a planet or even just a civilization ending event, Vanguard’s not for you. But then, no investments really are. You’re already stocking your underground shelter with canned goods. Short of that, you can sleep just fine with your assets at Vanguard. I do."

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If something happens to the mutual fund and it crashes, you lose everything.

Theoretically, yes, but the point of diversification is that the odds of ALL of the underlying stocks going to zero is infinitesimal. Certainly there can be large economy-wide crashes, which is why you can further diversify into multiple mutual funds covering different markets (real estate, bonds, international, etc.) to further reduce risk.

If you pick one apple off the tree, what are the odds that it's rotten? Now buy a basket of 100 apples. What are the odds that ALL of them are rotten? THat's the point of diversification. One company con go bankrupt, but the odds of the top 500 public companies in the US going bankrupt is virtually zero.

Does it make sense to invest in different index funds that track the same index, as a security measure?

No - that would be pointless. They should have roughly the same risk and return unless there's significant tracking error, which is possible, but the diversification benefit should be very small in that case.

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