Mutual funds are a popular and easily understood investment vehicle for many investors. For investors with limited knowledge, time or money, mutual funds can provide simplicity and other benefits. To help you decide whether investing in mutual funds is the right choice for you, here are a few key reasons to consider investing in mutual funds.
One perennial rule of investing, for both large and small investors, is asset diversification. Diversification involves the mixing of different types of investments and asset classes within a portfolio and is used to manage risk. For example, choosing to buy stocks in the retail sector and offsetting them with stocks in the industrial sector can reduce the impact of the performance of any one security on your entire portfolio. To achieve a truly diversified portfolio, you may have to buy stocks with different capitalizations from different industries and bonds with varying maturities from different issuers. For the individual investor, this can be quite costly.
By purchasing mutual funds, you are provided with the immediate benefit of instant diversification and asset allocation without the large amounts of cash needed to create individual portfolios. One caveat, however, is that simply purchasing one mutual fund might not give you adequate diversification. It's important to check if the fund is sector- or industry-specific. For example, investing only in an oil and energy mutual fund might spread your money over 50 companies, but if energy prices fall, your portfolio will likely suffer.
The Advantages Of Mutual Funds
Economies of Scale
The easiest way to understand economies of scale is by thinking about volume discounts; in many stores, the more of one product you buy, the cheaper that product becomes. For example, when you buy a dozen donuts, the price per donut is usually cheaper than buying a single one. This also occurs in the purchase and sale of securities. If you buy only one security at a time, the transaction fees will be relatively large.
Mutual funds are able to take advantage of their buying and selling volume to reduce transaction costs for investors. When you buy a mutual fund, you are able to diversify without the numerous commission charges. Imagine if you had to buy each of the 10-20 stocks needed for diversification. The commission charges alone would eat up a good chunk of your investment. Take into account additional transaction fees for every time you want to modify your portfolio and as you can see the costs start to add up. With mutual funds, you can make transactions on a much larger scale for less money.
Many investors don't have the exact sums of money to buy round lots of securities. One or two hundred dollars is usually not enough to buy a round lot of a stock, especially after deducting commissions. Investors can purchase mutual funds in smaller denominations, usually ranging from $100 to $1,000 minimums, although some funds will have a $2,500 minimum. Smaller denominations of mutual funds give investors the ability to make periodic investments through monthly purchase plans while taking advantage of dollar-cost averaging. So, rather than having to wait until you have enough money to buy higher-cost investments, you can get in right away with mutual funds. This provides an additional advantage: liquidity.
Another advantage of mutual funds is that you can get in and out with relative ease. In general, you are able to sell your mutual funds in a short period of time without there being much difference between the sale price and the most current market value. However, it is important to watch out for any fees associated with selling, including back-end load fees. Also, unlike stocks and exchange-traded funds (ETFs), which trade any time during market hours, mutual funds transact only once per day after the fund's net asset value (NAV) is calculated.
When you buy a mutual fund, you are also choosing a professional money manager. This manager will use the money that you invest to buy and sell stocks that he or she has carefully researched. Therefore, rather than having to thoroughly research every investment before you decide to buy or sell, you have a mutual fund's money manager to handle it for you.
The Bottom Line
As with any investment, there are risks involved in buying mutual funds. These investment vehicles can experience market fluctuations and sometimes provide returns below the overall market. Also, the advantages gained from mutual funds are not free: Many of them carry loads, annual expense fees and penalties for early withdrawal.