Investing can be complicated and very overwhelming. After all, there are so many different options out there, from stocks and bonds to real estate and money market accounts. Whatever you choose, there's no guarantee that you'll make money from your investments. But there is a way to take advantage of the opportunities available in the market by pooling your money into one vehicle: A mutual fund. You can certainly build wealth by investing in stocks, but it may be safer to invest in a mutual fund instead. So why should you seriously choose putting your money into mutual funds over stocks? Read on to find out some of the most common advantages that come with investing in mutual funds.
- Mutual funds pool money together from a group of investors and invest that capital into different securities.
- Mutual funds offer diversified holdings instantly and easily because they invest in a variety of securities.
- Investing in a mutual fund is a good way to avoid some of the complicated decision-making involved in investing in stocks.
- The cost of trading is spread over all mutual fund investors, thereby lowering the cost per individual.
The Basics of Mutual Funds
Mutual funds pool money together from a group of investors and invest that capital into different securities such as stocks, bonds, money market accounts, and others. Funds have different investment objectives, to which their portfolios are tailored. Money managers are responsible for each fund. They generate income for investors by allocating assets within the fund.
Mutual funds can hold many different securities, which makes them very attractive investment options. Among the reasons why an individual may choose to buy mutual funds instead of individual stocks are diversification, convenience, and lower costs.
Actively managed funds require a portfolio manager who constantly updates their holdings, while a passively managed fund's portfolio is built on a buy-and-hold strategy.
Ask any investment professional, and they'll likely tell you that one of the most important ways to reduce your risk is through diversification. It's a lesson most people learned after the financial crisis. The underlying theme here is that you shouldn't put all your eggs in one basket. So don't just invest in one industry or one type of investment vehicle.
Many experts agree that almost all of the advantages of stock diversification (the benefits derived from buying a number of different stocks of companies operating in dissimilar sectors) are fully realized when a portfolio holds around 20 stocks from companies operating in different industries. At that point, a large portion of the risk associated with investing has been diversified away. The remaining risk is deemed to be systematic risk or market-wide risk. Since most brokerage firms charge the same commission for one share or 5,000 shares, it can be difficult for an investor just starting out to buy into 20 different stocks.
That's where mutual funds come into play. Mutual funds offer investors a great way to diversify their holdings instantly. Unlike stocks, investors can put a small amount of money into one or more funds and access a diverse pool of investment options. So you can buy units in a mutual fund that invests in as many as 20 to 30 different securities. If you were looking for the same thing in the stock market, you'd have to invest much more capital to get the same results.
Mutual funds also invest in a variety of different sectors. So a large cap fund may invest across different industries like financials, technology, health care, and materials. Again, if you were to try to match this through individual stocks, you'd have to spend a lot of money to get the same returns.
The convenience of mutual funds is surely one of the main reasons investors choose them to provide the equity portion of their portfolio, rather than buying individual shares themselves. Some investors find that buying a few shares of a mutual fund that meets their basic investment criteria easier than finding out what the companies the fund invests in actually do, and if they are good quality investments. They'd prefer to leave the research and decision-making up to someone else.
Determining a portfolio's asset allocation, researching individual stocks to find companies well-positioned for growth as well as keeping an eye on the markets is all very time-consuming. People devote entire careers to the stock market, and many still end up losing money on their investments. Although investing in a mutual fund is certainly no guarantee that your investments will increase in value over time, it's a good way to avoid some of the complicated decision-making involved in investing in stocks.
Many mutual funds offer investors a chance to buy into a specific industry or to buy stocks with a specific growth strategy. Here are a few options:
- Sector funds invest in companies within a specific industry or sector of the economy
- Growth funds focus on capital appreciation through a diversified portfolio of companies that have demonstrated above-average growth
- Value funds invest in companies that are undervalued and are normally held by long-term investors
- Index funds allow investors to track the overall market by constructing a portfolio that tries to match or track a market index
- Bond funds generate monthly income by investing in government and corporate bonds as well as other debt instruments
The costs of frequent stock trades can add up quickly for individual investors. Gains made from the stock's price appreciation can be canceled out by the costs of completing a single sale of an investor's shares of a given company. Investors who make a lot of trades should take a look at our list of brokers who charge lower-than-average fees.
With a mutual fund, however, the cost of trading is spread over all investors in the fund, thereby lowering the cost per individual. Many full-service brokerage firms make their money off of these trading costs, and the brokers working for them are encouraged to trade their clients' shares on a regular basis. Though the advice given by a broker may help clients make wise investment decisions, many investors find that the financial benefit of having a broker just doesn't justify the costs.
It's important to remember there are disadvantages of mutual fund investment as well, so as with any decision, educating yourself and learning about the bulk of available options is the best way to proceed.
Most online brokers have mutual fund screeners on their sites to help you find the mutual funds that fit your portfolio. You can also search out funds that can be purchased without generating a transaction fee or funds that charge low management fees. The search function can also let you locate funds that fit into a specific style of investing like socially responsible funds.
Joe Allaria, CFP®
CarsonAllaria Wealth Management, Glen Carbon, IL
A mutual fund provides diversification through exposure to a multitude of stocks. The reason that owning shares in a mutual fund is recommended over owning a single stock is that an individual stock carries more risk than a mutual fund. This type of risk is known as unsystematic risk.
Unsystematic risk is risk that can be diversified against. For example, by owning just one stock, you carry company risk that may not apply to other companies in the same sector of the market. What if the company's CEO and executive team leave unexpectedly? What if a natural disaster hits a manufacturing center slowing down production? What if earnings are down because of a defect in a product or a lawsuit? These are just a few examples of the types of things that could happen to one company but are not likely to happen to all companies at once.
There is also systematic risk, which is risk that you cannot diversify against. This is similar to market or volatility risk. You should understand there is risk associated with investing in the market. If the market declines in value as a whole, that is not something that can easily be diversified against.
Therefore, if you'd like to invest in individual stocks, I would recommend researching how you can compile your own basket of stocks so you don't own just one stock. Make sure you are sufficiently diversified between large and small companies, value and growth companies, domestic and international companies, and also between stocks and bonds—all according to your risk tolerance. This is where it might be helpful to seek out professional help when constructing these types of portfolios. Just know, though, that this type of research and portfolio construction and monitoring can take quite some time.
The alternative is to invest in a mutual fund for instant diversification. Of course, there is a list of things to be aware of when choosing mutual funds as well. Fees, investment philosophy, loads, and performance are just a few components to consider when evaluating mutual funds.