Mutual funds offer a good alternative for investors who have limited time to watch the markets' ups and downs. They are investment pools that collect money from many investors and invest it in assets like stocks, bonds, a mix of both, or other securities. They are managed by professional advisors but owned by the investors. So, many investors chip in, and a fund manager calls the shots on what investments to buy for the group.
Most American households are invested in mutual funds. Why are they so popular? Below, we explain their advantages.
Key Takeaways
- Mutual funds offer diversification or access to a wider variety of investments than an individual investor could afford to buy.
- Investing with a group offers economies of scale, decreasing your costs.
- Monthly contributions help your assets grow.
- Funds are more liquid because they tend to be less volatile.
- Investors get professional investment management services.
Diversification
One golden rule of investing for the newest and most experienced investors alike is diversifying your assets when possible. By putting money into investments that act differently in the same economic conditions, you cut the risk to your overall portfolio. For example,buying retail and industrial stocks reduces the impact on your portfolio of a poor quarter in one of those sectors. Stocks might go down when interest rates are up, but that means your bonds are likely to pay more in interest.
Before the first publicly available mutual funds began selling shares in the mid-1970s, you needed wealth or expertise to have a portfolio of stocks from different kinds of companies across the economy, plus bonds with varying maturity dates from several issuers. By purchasing mutual funds, you get that diversification instantly.
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 to spread your assets among several leading industries. You'll take advantage of an increase in one of them while avoiding a big hit if one sector has a rough year.
The most popular mutual funds are life cycle or target-date funds. These offer diversification beyond one specific industry or asset type and change their holdings toward less risky and more income-producing assets as the target date approaches.
Economies of Scale
The easiest way to understand economies of scale is to consider volume discounts. In many stores, the more of a product you buy, the less it costs. A dozen doughnuts is usually cheaper per doughnut than buying three. This also occurs with 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. For the fund, they also save, generally, by having less staff per investor as their size increases, which should decrease your fee.
Fees vary widely. Most major fund managers offer no-load (commission-free) mutual funds, but you'll want to compare the expense ratio and any other costs that could eat into your savings over time.
Mutual funds use their trading volume to cut 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 only the initial purchase fees. Add the transaction fees for every modification to your portfolio, and the costs go up.
Divisibility
Most people investing in mutual funds do so each paycheck through their employer's 401(k) plan. But you don't need an automatic payroll deduction to sock away a regular round sum every month. Each time you do, you get another tiny bite of many assets. Stock-pickers, 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 Chipolte Mexican Grill (CMG).
These periodic investments in a mutual fund also allow you to take advantage of the benefits of dollar-cost averaging. This strategy cushions a portfolio from the impact of price volatility. You simply put the same amount in whatever the market is doing, which should be to your benefit over the long term.
So, rather than waiting until you have enough money to buy higher-cost investments, you can invest immediately in a mutual fund. This choice provides an additional advantage: liquidity.
Liquidity
An investor who is hit with a financial emergency might have to sell in a hurry. It can be disastrous if the assets have taken a hit at the wrong moment. This tends to be less of a problem with 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, unlike stocks and exchange-traded funds, mutual funds trade only once daily after the fund's net asset value is calculated.
Professional Management
When you buy a mutual fund, you also choose a professional money manager. This manager makes the decisions on how to invest your money based on extensive research and an overall strategy for making money. Only you can decide whether you are more comfortable with that than making the decisions on your own.
Convenience
Investing in a mutual fund is relatively simple, especially for those who can do so through payroll deduction. Unlike buying individual stocks or bonds, which require thorough research and figuring out the right brokerage platforms, mutual funds can be purchased directly through investment firms, financial advisors, or retirement accounts.
Another reason they are convenient is because they have low minimum investment requirements. Some mutual funds let investors buy in with no minimum at all (especially if it's done through your employer), and this means that even $5, $10, or $100 can get you invested. Thus, you can start investing with a smaller amount of money compared with buying individual stocks, which can cost significantly more per share. This flexibility is ideal for new investors who are just starting out or those who want to invest a smaller part of their savings regularly.
Employer Matching
About 65% of those invested in mutual funds do so through their employer. This provides more than just dollar-cost averaging through payroll deductions. Most employers offer some form of matching, from $0.50 to $1.00 for every buck you put in your 401(k). Not saving this way, then, leaves this money on the table, Peter Lazaroff, financial advisor and chief investment officer at Plancorp, told us.
He noted it's risk-free money—the match can double your stake before you get any returns from the mutual fund investment. Lazaroff suggests you try to max out on whatever match your employer provides. “You can still chip away at debt and put away small amounts in an emergency fund if necessary. But securing that employer match is crucial,” he said.
Fidelity reports that more than four out of five of those coming to them through their employers receive some form of matching. Vanguard says it's even higher for its plans, with about 95% of employers matching their employees and almost half providing non-matching funds—a certain amount of money whatever you put in.
The point is that it's worth checking how to maximize your investment by contributing the most you can while your employer matches you. The median match, by the way, is up to 4.5% of your salary.
What Are the Risks of Mutual Funds?
Mutual funds aren't guaranteed to rise in value. They can lose money along with the market, and their performance depends on the manager's skill. Always consider these risks before investing.
Can I Easily Sell My Shares In a Mutual Fund if I Need the Money?
Certain funds charge a fee if you sell your shares in a mutual fund. This fee is known as back-end load. It's a percentage of the value of the fund’s shares and is paid by investors when selling mutual fund shares. Additionally, investors who want to sell their shares before a specific deadline (usually within the first few months you're with a mutual fund) are subject to early redemption fees. There are also tax implications since whatever you take out will count as income that year.
Since Mutual Funds Are Professionally Managed, Can I expect Them To Outperform the Market?
Professional management doesn't guarantee market-beating returns, and past success isn't necessarily indicative of future results. The fund's performance depends on the specific holdings, the manager's skill, and, more generally, the market.
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: which fund to buy. There are almost 3,000 of them.
Mutual funds offer several advantages, making them the most popular choice among mainstream American investors. One of the primary benefits is diversification, which reduces the risk of loss by spreading investments across a wide range of assets.
Mutual funds also provide professional management, allowing you to leverage the expertise of fund managers who make investment decisions based on their research and analysis. Additionally, mutual funds offer convenience and accessibility. Another advantage is liquidity, as investors can typically buy and sell shares of mutual funds relatively quickly. This flexibility helps you tailor your approach to meet your financial goals.
