Companies succeed and fail all the time -- much like individuals do in their own careers. Putting all of one's stock into one currently successful company can result in financial disaster, but in a diversified mutual fund, the past record of a company is a far better guide, for these reasons:
1. With a fund's assets spread among the stocks issued by 50 or more companies, it is impossible for a change in profits of any one or even of several of those companies to have much effect on the fund's total income or market value. Of course, in a general business recession, diversification will not prevent a decline in a mutual fund's income and market value. But this lasts only a few years at the most; and when general business conditions improve again, a diversified fund moves along with the procession.
2. A mutual fund is not chained to its past, as most any other established business is. If the management of a manufacturing company decides to make a new product, it must conduct experiments, make changes in factory building and equipment, train personnel, and so on, all of which ties up a lot of capital, perhaps for several years, before the company can begin to make a profit on the new product. In contrast to the manufacturer, when a mutual-fund manager decides he had better get rid of the stock of "A" Company, and replace it with "B" Company's stock, all he has to do is to arrange for a broker to sell the one stock and buy the other.
A mutual fund has no need to hang on to a stock whose prospects are considered poor; and conversely, the fund has no alibi for not owning a stock if its prospects are believed to be better than some of those the fund does own.
This ability to switch promptly means that if the performance record of a fund shows that it has been a good picker of stocks in the past, the chances are strong that it will do equally well from now on. Or if a fund's performance record has not been so good, probably it will continue at the same level. Occasionally a fund wakes up and improves on its old record, but with plenty of other funds available, an investor need not buy shares in a reformed fund until the improvement actually shows up in its performance record for several years.
A fund's quality cannot be judged safely from its performance over too short a period of time. Perhaps five years is the shortest reasonable period, and maybe a few more years is better.
A mutual fund publishes tables of the present market value of a purchase of its shares made on certain dates in the past. It shows the results under three different conditions:
1. If a stockholder took both income and capital-gain dividends in cash.
2. If he reinvested capital gain dividends.
3. If he reinvested both kinds of dividends in additional shares of the fund. Probably the fund publishes another table showing the market value accumulated by having invested a uniform number of dollars every month for such a period as 10 years, with all dividends reinvested. These tables also show the amount of dividends for each of the three conditions just mentioned.
For the best results, always remember to study the history of the mutual funds in which you intend to invest. Have they made good choices in the past? That is the best indication of their future actions as well. Unlike investing in individual corporations that could conceivably fail at any time, mutual funds, due to their natural diversification, are a much safer bet.