The wide world of investment is full of opportunities. Unfortunately, along with these opportunities comes a lot of jargon and confusion. Common questions that people ask themselves are, “What are mutual funds?” and, “Should I invest in mutual funds?” Like most things in life, there are pros and cons to doing so. This breakdown will cut through the buzzwords so that you can get a better idea of what mutual funds are and whether or not investing in them is a good financial fit for you.
What is a mutual fund?
A mutual fund is defined as a company that pools money from many people and invests the money in securities such as stocks and bonds. The people who have put money into these mutual funds have bought shares of the portfolio and in return receive some of the income that it generates. Currently, the market houses more than 7,000 different mutual funds.
Why wouldn’t I just invest in stocks and bonds on my own?
You could! Or you could invest in both mutual funds and individual securities. Part of what attracts people to mutual funds specifically is that professionals choose the securities and manage the portfolio for you. Not only does this tick some boxes on your long to-do list, it also should mean that someone who is more educated in investing than you is calling the shots. Mutual funds can help the average Joes and Janes of the world invest with confidence. However, you should still do your own research to make sure both the fund and the manager themselves are sound and align with your objective.
What’s an objective?
This is basically what your goal for investing is, be it long-term or short-term growth. A good practice before investing in anything is assessing your financial goals and risk tolerance. If your financial goals are off in the future (perhaps you’re a young person beginning to save for retirement), you may have a higher risk tolerance as you will have more time to make up for any losses that could occur over the years. Conversely, if you are quickly approaching retirement then you’re looking for short-term growth and your risk tolerance is probably lower as you won’t have much time to make up for any losses. As you can see, your situation will inform you of your goals and tolerance, and in turn you can find a mutual with an objective that matches your own.
What type of assets should make up the mutual fund I invest in based on my objective?
If you have a high risk tolerance, investing in a stock fund might be the right choice for your finances. This is a very aggressive investment strategy. On the other hand, if you have a low risk tolerance, go for the conservative choice of a bond fund. Your returns might not be as high, but they will be more consistent and also your losses will not be so low. Although, it is important to note that there are many different types of bonds that each have their own level of risk. Also, tolerance is a scale, which is why there are so many different types of mutual funds, including balanced funds that are made up of a mix of stocks, bonds, and other securities.
Are there any other arguments for mutual funds?
Another bonus of mutual funds is that they are usually diversified, meaning that they invest in multiple companies across a variety of industries. This makes many mutual funds less risky than investing in a few specific stocks because it means that if one company or industry is suffering, you’re more likely to have shares in others that are still producing returns. However, sector funds, which specialize in a particular industry sector, exist as well.
Are there any arguments against mutual funds?
Many are put off by the fact that mutual funds come with fees, and the structure of these fees can be complex and confusing (although they can usually be easily navigated with the help of a financial advisor). Every mutual fund charges an annual expense ratio to cover overall operating and management expenses. They may also charge load fees when you buy or redeem shares. The thing is, there are plenty of services we pay for simply because we don’t want to do a task or because we wouldn’t be able to do it as well as a professional. It might be time to call the plumber, as they say. The good news is that there are plenty of affordable mutual funds out there that have relatively low costs for both the initial investment and subsequent purchases. A lot of the pricing has to do with whether a fund is actively or passively managed.
What’s the difference between an actively managed fund and a passively managed fund?
Mutual funds that are actively managed essentially try to beat the market. This process requires more money and more work on the fund manager’s part, which understandably results in larger expense ratios and load fees. Passively managed funds try to copy the market instead of thinking one step ahead. They usually track an index of different securities, such as the S&P 500, which consists of the 500 U.S. companies with the biggest market capitalization. This requires less management so the fees are usually lower than an active fund’s would be.
Really, there are mutual funds out there that fit every objective with fees at varying price points. If you’re still overwhelmed by the thought of choosing which ones to invest in, a financial advisor can offer you helpful guidance. There are also multiple credible websites that can help you research mutual funds, such as Morningstar, Lipper Leaders, Kipling Mutual Fund Finder, MAXfunds, and FundReveal.
And, of course, there are people who simply enjoy doing their own investing. It all depends on what you’re into and what your goals are. Choosing individual securities on your own can be quite risky, but perhaps that’s part of the fun for you. After all, with great risk can come great reward. However, if dabbling in stocks on your own is your only investment strategy and you’re beginning to approach retirement, it’s probably time to consider making some changes. There are certain times in life when the possibility of a reward is no longer worth risking a great loss. Mutual funds might help to balance your portfolio out.