With mutual funds as popular as they are, every investor needs to know mutual fund basics. Fundamentally, they simply consist of investors pooling their money together to purchase various types of investments to share both the risks and rewards. While they have certain advantages that make them very popular, there are also drawbacks that all those purchasing mutual funds need to consider.
Mutual funds in a sense offer people the safety of banding together. They work by pooling money from many investors and putting it under professional management. This gives investors opportunities to participate in markets and products that would otherwise be closed to them.
Advantages of mutual funds
This banding together of investors offers various advantages, and diversity is one of the most important ones. Diversity is recommended for most investors since it offers a way to minimize risk. Mutual funds enable investors to diversify into a far greater number of investments than would otherwise be possible.
Since many investors do not have the time or interest to closely follow the markets, having their money under 24/7 professional management in mutual funds is a very attractive feature. If they pick good funds, those investing usually do not need to give too much thought to the markets as long as they are in it for the long haul.
Finally, there is the ease and economies of scale that mutual funds offer. With their size, mutual funds can purchase securities at far lower sales charges. They can also offer savers very easy ways to invest such as automatic monthly deductions from their paychecks.
Disadvantages of mutual funds
Those seeking to understand mutual fund basics certainly need to be aware of their disadvantages too. An important one is costs. Professional management costs money and even no-load funds have cost ratios that must be paid every year, including those in which the fund loses money.
There is also the loss of control as to when capital gains are taken. When funds buy and sell stock during any given tax year, they can trigger capital gains that the holders of those funds must claim for that year, even if the investor has not bought or sold any of the fund’s shares. Thus, investors lose control over when they can take their capital gains and may have to pay taxes on them even in years where the funds declined in overall value.
Investing in mutual funds
While mutual funds have minimum investment requirements to join, getting started is usually a relatively straightforward process of filling out some forms and making the initial investment. But to pick the right funds, every investor needs to know mutual fund basics.
Different types of funds
With so many mutual funds out there, they can be classified in different ways. They are commonly divided into three major types:
Equity funds consist of common stocks and are considered the riskiest.
Fixed-income funds made up of government and corporate bonds that have lower risks and a steadier, but lower, average returns.
Balanced funds which are a mixture of fixed income and equity funds
These categories can be subdivided in many ways. For example, equity funds can be divided into large-cap, medium-cap and small-cap. Also, some funds will concentrate on domestic, international or regional stocks. There are even mutual funds for mutual funds While it is not practical to cover every type of fund, diversity should be sought where practical.
Picking a mutual fund
Every investor needs to choose the type of fund that best suits their needs and tastes. Generally, those types of funds that offer the largest potential return are also those that pose the greatest risk. Age, finances, investing goals and any other pertinent factors for the investor need to be taken into consideration. Carefully read up on the different funds and compare their performance records.
Types of mutual funds offers more details on the kinds of funds that should be considered when purchasing.
It also should be noted that mutual funds, primarily international mutual funds, make it easy for people to diversity their investments to wherever the best returns can be found worldwide.
Those who buy mutual funds
Being such an important investment, mutual funds should only be purchased after careful research. There are many great funds that give excellent returns, but mutual funds generally do not greatly outperform markets as a whole. Moreover, past success cannot be an assurance of future gains. For these reasons, it is vital never to overlook mutual fund costs (expense ratios). Investors need to be especially wary of load funds and favor no-load mutual funds when possible. Furthermore, index funds or ETFs, are a great way to get many of the benefits mutual funds at lowers costs.
While investors can go into great depth if they choose, the mutual fund basics are not so complicated that anyone cannot understand them and make good investment choices.