Contents
Mutual Fund Basics
Why Invest in Mutual Funds?
Mutual Fund Returns
Types of Mutual Funds
Mutual Fund Investment Holdings
Funds vs. ETFs, Stocks, and Bonds
How to Plan a Mutual Fund Portfolio
How to Research Mutual Funds
How to Buy Mutual Funds
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Why Invest in Mutual Funds?
People invest in mutual funds for several reasons:
- Diversification
- Convenience
- Professional management
- Liquidity
- Government regulation
Diversification
Diversification is the practice of spreading one’s investments among different types of securities (stocks, bonds, real estate and so on) in order to reduce risk. In investing, a direct relationship exists between risk and return:
- The more risk you take on, the greater the potential return relative to the market as a whole—and, in the same way, the greater the potential losses.
How Mutual Funds Aid Diversification
Mutual funds allow you to build a diverse investment portfolio, even with just a few thousand dollars to invest. Though most individual mutual funds focus on just one type of security—such as stocks only, or bonds only—each fund typically holds dozens, hundreds, or even thousands of different individual stocks or bonds. So by owning one stock fund, you’re essentially owning thousands of stocks. And by owning one stock fund, one bond fund, one real estate fund, and so on, you can spread your investments across many different types of securities, which in turn can help reduce the risk of owning just a few individual stocks or bonds.
Mutual Funds and Overdiversification
The goal of building a diverse investment portfolio is to beat the performance of the market as a whole and limit risk. Overdiversification occurs when an investment portfolio contains so many securities that it ends up matching, rather than beating, the performance of the overall market. As mutual funds grow in size, fund managers scramble to invest their cash. In doing so, they often stop buying investments for the right reasons, such as outperforming the market, and instead end up with a diverse batch of securities that together end up mimicking the market. Overdiversification is one of the main reasons why almost 70% of actively managed mutual funds fail to outperform the market (for more on actively managed funds, see Types of Mutual Funds).
Convenience
Mutual funds allow you to own a stake in a broad array of investments by buying just one investment, meaning that you can quickly build a diversified investment portfolio by buying just a few mutual funds. Owning just a few funds can make your financial life much easier for these reasons:
- Tracking performance: Owning many individual securities makes monitoring the performance of your portfolio demanding and time-consuming. Owning a mutual fund, or a portfolio of just a few funds, simplifies this task since you need only keep track of overall fund performance, not the performance of each of the many securities that comprise each fund. At the same time, if you own mutual funds it’s often difficult to keep track of precisely which securities your funds own. It’s easier to know exactly what you own if you buy individual stocks, bonds, and so on.
- Buying an exact dollar amount: Unlike stocks, mutual funds can be purchased in fractional shares. This flexibility allows you to buy a specific dollar amount of a fund, rather than only a whole number of shares.
- Simplifying your taxes: Figuring out the taxes you owe after selling various individual securities requires thorough recordkeeping and can lead to costly accounting bills. When you own mutual funds, your fund company will tell you exactly what taxes you owe each year at tax time.
Professional Management
Mutual funds employ managers with training and extensive investing experience. When you buy a mutual fund, you’re also buying the expertise of the fund manager and his or her staff. In addition to expertise, you also get accountability—mutual fund companies are required by law to publish annual fund-performance statistics. When you buy individual securities, you must rely on your own expertise and accountability, which may be daunting or stressful.
Liquidity
Liquidity refers to the ease with which you can convert your investments to cash. Mutual funds are highly liquid. A mutual fund can be sold on any day on which a net asset value is calculated for the fund—usually Monday through Friday. All mutual fund trades, however, have a settlement date on which you actually receive the money for your fund (if you sell) or the fund shares (if you buy). The settlement date for a mutual fund transaction may be 1–3 days after the trade is processed.
Government Regulation
Various U.S. government agencies monitor and regulate the mutual fund industry. Some of the benefits of government regulation include:
- Full disclosure: On a quarterly basis, funds must disclose data about investing strategies, performance, costs, and holdings. Full disclosure ensures that all fund investors invest based on the same information.
- Voting rights: Funds must conduct a vote and receive the approval of a majority of all shareholders in order to make major changes in the way they operate. The voting process treats individual investors equally alongside fund managers and big shareholders.
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