For investors with limited time to spend watching the ups and downs of the markets, mutual funds offer a good alternative. Here are a few reasons to give up individual stock-picking and turn to mutual funds.
One golden rule of investing for both large and small investors is to go for asset diversification. That involves reducing the risk to your assets by buying a mix of stocks from different industries and investments of different types. For example, buying both retail and industrial stocks reduces the impact on your portfolio of a poor quarter in one of those sectors. And putting some of your money in bonds protects you from a precipitous drop in stocks.
- Mutual funds offer diversification or access to a wider variety of investments than an individual investor could afford to buy.
- There are economies of scale in investing with a group.
- Monthly contributions help the investor's assets grow.
- Funds are more liquid because they tend to be less volatile.
- The investor gets professional investment management services.
To achieve a truly diversified portfolio, you would have to buy a number of stocks of companies in various industries plus bonds with different dates of maturity from a number of issuers. Such a wide selection is beyond the reach of most individual investors. By purchasing mutual funds, you get instant diversification.
One caveat, however, is that you might not get adequate diversification by investing in a single mutual fund. Don't put all your money in a single sector-specific or industry-specific fund. An oil and energy mutual fund might spread your money over 50 companies, but if energy prices fall, your savings will suffer. Instead, look for a fund that will spread your assets among a number of leading industries. You'll take advantage of a pop in any one of them while avoiding a big hit if one sector has a rough year.
The Advantages Of Mutual Funds
Economies of Scale
The easiest way to understand economies of scale is to consider the volume discount. In many stores, the more of a product you buy, the less it costs. A dozen donuts can be cheaper than three. This also occurs in the purchase and sale of securities. If you buy one share of stock, the transaction fee will be the same as if you bought 1,000 shares. That's a hefty bite out of your investment in one share, but a negligible nibble out of 1,000 shares.
Fees vary widely. Read the fine print to understand what fees you will pay for investing in the fund.
Mutual funds take advantage of their buying and selling volume to reduce transaction costs for their investors. When you buy a mutual fund, you diversify without paying the 10 to 20 transaction fees that would give you a similarly diverse individual portfolio. And that's just the initial purchase fees. Take into account the transaction fees for every modification to your portfolio and the costs add up.
The owner of a mutual fund can invest a regular round sum every month, say $100 or $200. That gives the investor another tiny bite of many assets. A stock-picker, by contrast, might get one or two shares of stock, with an odd number of dollars left over. Or, the investor can save up for many months to get one share of Amazon.
These periodic investments in a mutual fund also allow the investor to take advantage of the benefits of dollar-cost averaging, a strategy that cushions a portfolio from the impact of price volatility.
So, rather than waiting until you have enough money to buy higher-cost investments, you can get in right away with a mutual fund. This choice provides an additional advantage: liquidity.
An investor who is hit with a financial emergency might have to sell out in a hurry. That can be disastrous if the assets have taken a hit at the wrong moment. It tends to be less so in mutual funds, which swing in value less wildly because of their diversification.
Watch out for any fees associated with selling, including back-end load fees, which are percentages deducted from your total when you sell the fund. Also, note that mutual funds, unlike stocks and exchange-traded funds, transact only once per day after the fund's net asset value is calculated.
When you buy a mutual fund, you also are choosing a professional money manager. This manager makes the decisions on how to invest your money, based on a good deal of research and an overall strategy for making money. Only you can decide whether you are more comfortable with that than with making the decisions on your own.
The Bottom Line
If you decide to forego stock-picking and go with a mutual fund, you still have one last investment decision to make, and that is which fund to buy. There are thousands of them out there.
Read the prospectuses until you find one that matches your attitude toward risk-taking or risk-avoidance. Read the fine print to understand what fees you will pay for investing in the fund, as they vary widely.
Finally, understand going in that even mutual funds experience market fluctuations and may even provide returns that are below the overall market.