In addition to being generally more affordable than investing in most blue-chip stocks, mutual funds are tailored to different investing goals and risk tolerance levels. Professionals are responsible for managing mutual funds; their entire careers are based on seeing the funds turn a profit.
What Is a Mutual Fund?
A mutual fund is actually a particular type of investment company that pools the collective contributions of the fund's participants and invests those dollars in a portfolio of securities. While the term "mutual fund" technically refers to the investment firm, it is also commonly used to refer to the portfolio itself.
Instead of simply buying shares of a few stocks, you can choose to purchase shares of a mutual fund that holds investments in stocks, bonds or money market securities. Each share of a mutual fund entitles you to a portion of the fund's assets.
Mutual funds, like stocks, are highly liquid assets; you can buy and sell shares at any time. While mutual fund shares are generally traded directly through the fund itself rather than on a market or exchange, buying and selling mutual fund shares is just as easy as trading stocks. You can liquidate your investment quickly and at your own discretion.
The Benefit of Diversification
One of the greatest benefits of mutual funds is that they enable investors to diversify their investments with little effort. If you invest all of your money in a single stock, there is a substantial risk of loss if the issuing company's performance loses steam. If you invest in a variety of stocks in different sectors, you reduce your risk; the odds of all the companies failing simultaneously are slim.
It takes a lot of research and capital to create a properly diversified portfolio when you're investing in the stock market. If you invest in a mutual fund instead, all the guesswork is taken out of the equation. The prospectus, annual performance and asset allocation documents tell you what the fund is invested in and how it has performed historically. Rather than researching dozens of different stocks individually, you can simply search for mutual funds that meet your investment goals.
The Benefit of Customization
Another benefit of mutual funds is the fund managers' ability to tailor investment vehicles that meet differing investor goals and risk tolerance levels. Creating a properly customized portfolio that meets your specific needs when you're investing in individual stocks requires a comprehensive understanding of technical indicators and a grasp of fundamental analysis and technical analysis. Without a firm understanding of historical volatility, corporate finance and charting patterns, investing in individual stocks often comes down to little more than guesswork.
There are four main types of mutual funds: stock funds, bond funds, balanced funds and money market funds. Any given investment firm is likely to offer a wide range of funds from different categories, making it easy to choose a fund that reflects your investment style.
For example, if your main goal is wealth creation, choose stock funds; they are typically high-risk and high-reward. If you want to preserve capital and you will accept low returns in exchange for maximum security, choose money market funds. If capital preservation is your primary goal and the creation of regular income is secondary, bond funds provide guaranteed periodic interest payments and offer a high level of security.
If you want some level of investment security without completely forsaking the possibility of big gains, balanced funds include both stock and bond investments in varying ratios to accommodate differing needs. A stock-heavy fund is generally riskier but carries the potential for bigger gains, while a bond-heavy fund provides lower risk with steadier, safer growth.
The Benefit of Oversight
What makes these benefits possible is investment oversight. Mutual funds take all the legwork out of investing. Each fund is managed by professionals whose sole purpose is to generate profits. Fund managers are motivated to design profitable portfolios, and they have the knowledge and experience most individual investors can only dream of.
When investing in individual stocks, you are responsible for both the research and the execution of your trades. You must know a good deal about the stock you've chosen, and you must also be actively involved in the day-to-day activity of the stock market. There is a lot of money to be made in swing trading or other short-term strategies, but it requires that you keep one eye on the chart at all times. If you mis-time your trade, you may end up missing out on big gains – or worse, losing your original investment.
Mutual fund managers do all of the research, calculation and trading for you, making mutual funds a simple and lucrative investment option. If you enjoy a highly active trading style or you need to have constant control over how and when trades are executed, you may not enjoy this type of set-it-and-forget-it investment. Stock funds offer similar rewards to investing in the stock market, but with a degree of professional guidance that most individual investors cannot access.
The Benefit of Affordability
Another major benefit of mutual funds is their affordability relative to investing in individual stocks. Many of the biggest performers on the market today have prohibitive share prices upward of $500. Many investors don't have the capital to invest in more than a handful of shares at a time, meaning the returns likely don't justify the expenditure.
Mutual funds often sell shares for as little as $100 and make it easy to make additional investments automatically over time to grow your holding. If you have $10,000 to invest, you could buy only 20 shares of a stock selling for $500 per share, or you could purchase 100 shares of a mutual fund that has a diversified portfolio and professional management.
In addition, if you buy and sell stocks frequently, the brokerage fees alone can be a substantial drain on your profits. If you have a large amount of money to invest and know enough about the stock market to time a few big trades perfectly, you may be able to make impressive gains in a short period without incurring too many fees. Most investors, however, aren't so lucky.
Because mutual funds leverage the investments of thousands of shareholders, they can limit the cost of investing. Mutual funds buy and sell securities frequently, making hundreds of trades per year. As an individual investor, the fees incurred by that kind of activity would be astronomical. Mutual funds, however, spread the cost of those trades among the thousands of shareholders, greatly reducing the cost per person.