Mutual funds are baskets of stocks or bonds, and they come in all different shapes and sizes. Some mutual funds cover broad stock market indexes like the S&P 500, while others focus on specific sectors like energy or healthcare. Whether you’re buying individual stocks, bonds, or ETFs (also known as exchange-traded funds), it’s important to have an understanding of mutual funds before making your investment decisions. Here’s everything you need to know about mutual funds, including the advantages and disadvantages of this popular investment vehicle.
Types of Mutual Funds
There are two main types of mutual funds: no-load funds, which don’t charge investors any fees when they buy shares; and load funds, which do charge an entrance fee to invest. (The exception is exchange-traded funds (ETFs), which don’t have any fees attached to them.) There are also closed-end funds, mutual funds that trade on stock exchanges like stocks. Unlike other mutual funds, these don’t continually reinvest your dividends; instead, they use your money to buy more shares in order to drive up their price. And there is a tax-exempt municipal fund, designed specifically for investments in tax-free bonds issued by states or municipalities.
Allocating Assets
Pros and Cons
Managers of mutual funds decide how to invest. If they do their job well, your returns will be good; if they don’t, you won’t do as well as an investor in a better-run fund. With that said, it’s worth noting that actively managed funds are less popular now than they were decades ago due to high fees and disappointing performance compared with index funds. What’s more, many managers who were famous for beating benchmarks in one decade may not repeat their success in another. What should you do with all of these considerations in mind? The answer is simple: avoid actively managed mutual funds unless there’s a compelling reason why you can’t stick with index funds (such as having an ultra-conservative approach to investing).
Understanding Fees
Because many mutual funds make money by charging expenses to investors, it’s important that you understand what fees are involved. There are three major kinds of fees: 1) an annual fee for being in a fund; 2) a charge if you sell shares (also known as a redemption fee or exit fee); and 3) fees for buying shares from a brokerage (known as transaction fees). Altogether, these fees add up to what’s called an expense ratio—and it tells you how much your investment costs each year. The higher your expense ratio, generally speaking, the more you’ll pay in management expenses over time. A manager can choose whether or not to include these costs in his performance calculation.
Deciding When to Buy or Sell
When you’re just starting out, it can be tempting to jump in feet first with a mutual fund investing strategy. You might think, If I invest my money now and make some good picks, I’ll have a nice nest egg by age 65. It all sounds so easy! The truth is that unless you’re willing to do more research than anyone has time for, you should wait until after your retirement date to think about mutual funds. That way you won’t have to spend every day fretting over whether or not today is a good day to buy or sell. Let someone else do that while you enjoy yourself during retirement!
Diversification Reduces Risk
The main reason to invest in mutual funds is diversification. In other words, if you have a portfolio of mutual funds, it’s less likely that any one company—or even industry—will be completely responsible for your investment losses. This reduces risk but does not eliminate it. Diversification does not ensure a profit or protect against loss in declining markets. It does provide greater potential for gains when the overall market is rising than individual securities would offer.