Mutual Funds
What is a mutual fund?
A mutual fund is when a pool of investors invest their money is stock that would be out of their reach if investing alone. A mutual fund chooses an investment, such as large cap growth stocks, from a prospectus. A mutual fund investment manager will then invest on behalf of the pool of investors. As it is a combined effort, each investor can be part of a mutual fund with a relatively small amount of money. More....
What are Stocks?
Stocks are the most common ownership investment traded on the market. Stocks are shares in public companies, such as Pepsi, Microsoft or Virgin.
What are Bonds?
Bonds are the most common lending investment traded on the market. When you buy bonds you are effectively lending your money to a company in order to receive a return with interest.
Other types of investments include annuities, real estate, and precious metals. When dealing with mutual funds however, the vast majority of investments are with stocks and bonds.
Mutual fund pros and cons
Let’s begin with the good news. Many people choose mutual funds and take advantage of the following benefits:
- 1) A small amount of money can get access to a broad range of securities.
2) A foreign mutual fund gives exposure to overseas securities – which is impossible for most individual investors.
3) Professional fund management made up of traders who specialize in large investments are strategizing and handling your money.
Mutual fund disadvantages may be outweighed by the benefits, but nevertheless, you ought to consider the following:
- 1) As part of a mutual fund, an investor has limited control over the money.
2) An investor has to trust his fund manager.
3) If other investors withdraw from the pool it could force the manager to sell securities. The result of which could mean you are forced to pay taxes to cover transaction charges.
Mutual fund costs and fees
A mutual fund has several types of costs for the investor to consider.
Purchasing the security
When your mutual fund is purchasing securities there will be a commission fee incurred. While the investment pool will not necessarily be billed for this fee, it will be represented in the net performance.
Management fees
Simply put, this cost is what the fund charges the investors for managing the investment.
Load fees
What is a load fee? A load fee is really a sales charge and represents the commission that is paid back to the broker firm for selling you into a mutual fund. There are three common types of loads.
Front-end load
A front-end load is an upfront percentage of your initial investments, usually between 3%-5%. This service fee will be paid back to the broker firm.
Back-end load
A back end load is a sales charge which decreases over the course of your investment, eg, it may start at 6% but will decrease as time progresses. If you pull out of the investment pool prematurely, you will be liable to pay the remaining percentage.
Annual load
An annual load must be paid yearly, (as the name suggests) and can be anything from 0.25% to 1%.
No load funds
No load funds are less expensive because there is no sales commission to pay back to the broker. In saying that, this does not mean your mutual fund does not have any costs or fees attached to it, there will still be management fees.
NB: Choosing the right load really depends on the level of your investment, your ambitions and the length of time you expect to remain in the fund. By carefully considering your strategy you should be able to determine which, if any, provide the best option.
What does a fund manager do?
Your fund manager has complete responsibility for the running of your investment. If it is a stock fund, your fund manager will decide which stocks to invest in and which ones to sell. Your fund manager is the decision maker on securities, which ones present good value and which ones are to be avoided. The fund manager oversees the strategy of your investment based on experience; the amount of money invested and market conditions.
Common mutual fund mistakes
The most common mistake people make with mutual funds is not taking into account the overall strategy of the portfolio. In other words, having a fund with no real objective in mind and without knowing how it fits in to the rest of your portfolio can sometimes prove costly.
Choosing a fund based on past performance
Although people know that past performance does not predict how a fund is likely to perform in the future, may investors choose a security based on it’s historical record. Some investors even choose a fund on the recommendation of an independent ratings company; the problem with this is they too suggest funds based on past performance. Choosing an investment fund using past performance as your main guide gives you many similar investments, when what you should be striving for is diversity.
Investing with a ‘rookie’ fund manager
When choosing a fund it is important to ask how long the fund manager has been in place. A fund’s performance is always linked to the fund manger because it is he/she who makes the day-to-day decisions to either buy or sell securities. Therefore, the tenure of a fund manager is an important consideration. A fund manager who is new to the investment and is not familiar with its previous form may not be the best steward of your money.
Investing in trendy stocks
Investing in trendy stocks can be risky business. A trendy stock is not suitable for long-term investors because like the name suggests, it is only going to be profitable while the trend lasts. Also, if many investors pull out of the fund, those who have remained in the pool incur the costs of the transactions – which can be very expensive.
Mutual Fund versus Individual Stocks
Getting access to some stocks can be difficult on an individual basis. For this reason mutual funds give people access to securities that would otherwise be unobtainable to the average investor. This is equally true of foreign securities that can only be bought via a foreign mutual fund. Although buying securities is probably more fun if you act independently, the fact remains that investing is serious business.
Debts has compiled a list of reasons why investing in mutual funds is more favorable than acting on an individual basis.
Safety
If you are deciding whether to buy stocks individually or as part of a mutual fund, one of the key factors to consider is safety.
If prone to making emotional decisions, you may be better putting your money and your decision-making in the hands of a professional fund manager. A good fund manager will be experienced enough to rely on instincts rather than flashing dollar signs. Gambling is difficult to do without becoming emotionally involved and it is when our emotions run high we run the risk of making mistakes. Investing is much like gambling, in that the outcome is never certain, therefore you may life to play safe and let the professional trader make the important calls.
Diversification
Diversification is the secret of every successful investor. If an investor has acquired wealth by not having a diverse range of stocks or bonds, it is only because they have been able to purchase large amounts of one security.
The reason for diversifying is straightforward – it greatly reduces risk without sacrificing on returns.
Large scale investments
Mutual fund companies can use the money from a pool of investors to purchase stocks in bulk. Large sums of money means the mutual fund company can often trade commission-free and utilize their contacts at brokerage firms for the benefit of everyone – especially the investors.
Portfolio management
Unless you have lots of time and a good head for complicated bookkeeping, mutual funds are always the better option. Managing your portfolio is a full time job and nothing other than total commitment will ensure success. A fund manager has both the time and experience of keeping track of stock markets and investors’ assets.
Liquidity
If it is high liquidity you are after then mutual funds are your answer. We all find ourselves in situations when we need money fast. Gaining access to money invested in a mutual fund is easy. If your fund manager receives your request in time, money can be in your bank account when markets close that same day. Alternatively, you can have a check mailed to you by post.
Some mutual funds have a check writing facility, which can be used in the same way as a regular checking account.
NB: Gaining access to money tied up in stocks can be difficult depending on the type of investment. Certificate of Deposits (CD’s) offer no liquidity whilst bonds can also be subject to tight restrictions.
Cost effectiveness
Individual investors often have to pay transaction fees that can be in the region of $18. For the small investor who is putting away $100 every month, the total investment is already down 18%. It is therefore clear to see that this method of investment makes it extremely difficult for the small investor to make any real money.
Mutual funds, however, give new investors the chance to invest any amounts of money, regularly, without the heartbreak of trading costs. A mutual fund, has mutual respect (word play intended) for all investors, no matter how much or how often they invest.
Lower risk
As we have already seen, mutual funds offer investors a way to invest without the risk associated with stocks. Diversification is one reason and the services of a professional fund manage is another. However, certain mutual funds can be riskier than individual stocks so it does pay to do some homework.
One of the major risks associated with individual stocks is corporate bankrupty. If a company you have purchased stocks in goes bust, you lose your entire investment overnight. However, because putting your money in a mutual funds is a lot like spread betting, the chances of corporate bankruptcy wiping out your investment is extremely remote. Especially when you consider mutual funds can carry a portfolio of 25-5000 companies.
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