Advanced Diploma of Financial Planning (ADFP) Practice Test

How do mutual funds help in diversifying an investment portfolio?

1. They invest only in real estate

2. They are limited to a single type of security

3. They provide broad diversification with a minimum investment requirement

4. They focus on high-risk assets only

The correct answer is: They provide broad diversification with a minimum investment requirement

Mutual funds play a significant role in diversifying an investment portfolio because they pool money from multiple investors to invest in a wide array of securities, such as stocks, bonds, and other assets. By offering broad diversification, mutual funds allow individual investors to gain exposure to a variety of investments without the need to buy each security individually. This reduces the risk associated with investing in a single entity or sector, as the performance of the fund is not solely dependent on one investment. Investing through mutual funds typically comes with a relatively low minimum investment requirement, making it easier for investors to spread their capital across different asset classes and sectors. This broad diversification helps to mitigate risk, as losses in one area can potentially be offset by gains in others. The other options reflect misconceptions about mutual funds. For instance, they do not exclusively invest in real estate or focus solely on a single type of security; rather, they can cover a wide range of sectors and asset classes. Additionally, mutual funds are not limited to high-risk assets; they can include a balance of high-risk and low-risk investments, catering to various investor risk tolerances.