Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic diversification they offer, as well as the advantages of professional management, liquidity and customizability.
Diversification is the name of the game in investing, as it allows the investor to spread out his total risk over a wide range of investments. To achieve optimal diversification in a self-managed portfolio, the investor or his financial advisor needs to research and track numerous investments in different sectors and markets.
To balance out highly volatile stock holdings, for example, you need to also include highly stable bonds in your portfolio. While highly volatile stocks may end up generating huge gains, they are just as likely to cost you a significant amount of your investment capital. Government or highly rated corporate bonds, conversely, are unlikely to lose any principal value over time and are guaranteed to pay a fixed amount of interest each year. These bonds, therefore, are extremely low-risk but also offer lower profit potential.
This is an extremely simple example of diversification. In reality, complete diversification is much more complex. Mutual funds are popular because all the legwork of creating an optimally diversified portfolio is taken care of by the fund's managers. This intrinsic diversification makes mutual funds generally safer than investing in individual stocks.
Another reason mutual funds are so popular is because they are managed by professionals who have the experience necessary to properly judge the profitability of different investments. Unlike individual investors, fund managers are less likely to succumb to the pitfalls of emotional investing motivated by greed and fear. Fund managers are also uniquely motivated to ensure their funds are as profitable as possible regardless of their own opinions of the companies or governments that issue assets in the fund's portfolio.
In addition, investing in a mutual fund ensures the investor does not need to worry about researching and timing trades. With professional management, the fund's manager handpicks each asset and decides when and how to buy or sell to generate the highest returns.
One of the chief benefits of investing in the stock market is investors can buy and sell shares at will. Similarly, shares in open-end mutual funds can also be purchased or sold at the discretion of the shareholder. While mutual fund shares are not traded on a market like stocks or bonds, shareholders can redeem shares with the fund directly or through a registered broker. Most mutual funds, therefore, are just as liquid as traditional stock investments but with the added benefits of diversification and professional management.
Another important factor contributing to the popularity of mutual funds is there is an almost infinite number of products available. Regardless of your investment goals or risk tolerance, there is a mutual fund that meets your needs, from high-risk, high-reward stock funds to minimal-risk funds that offer slower, steadier growth, as well as everything in between.
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One of the main reasons mutual funds have become popular is due to their low minimum investment amounts. A typical minimum investment is $1,000 to start, then even less for additional investments or redeployments, making them accessible to most investors.
Moreover, index mutual funds have gained popularity recently since the market indices have performed exceedingly well. The fact that they are diversified across multiple asset classes also makes them attractive.
With that said, there are alternatives to mutual funds with different structures that also provide diversification benefits. Unit investment trusts (UITs) invest in a fixed portfolio of securities usually with a 12-24 month term. Therefore, they do not charge annual expenses like mutual funds, only an upfront commission.