Mutual funds are a great option for first-time investors, veterans, and anyone in between. Although they may not be the most exciting investment vehicles, and individual stocks may produce greater yields at some times, mutual funds still have huge advantages. They are simple to use, allow for diversification even with a small investment, and allow small investors to take advantage of professional management.
Let’s look at what mutual funds are and why mutual fund investing for beginners is so appealing.
What are Mutual Funds?
Mutual funds allow investors to pool their money with that of other investors. The pooled money is used to purchase a package of stocks, bonds, or other investment instruments, which is managed by investment professionals. Since many beginner investors have limited funds, a mutual fund makes it easier to hold a wide variety of assets and to hold stocks of companies with high per-share prices.
Types of Mutual Funds
Investors can choose from many types of mutual funds. Some of the most common options include:
- Growth funds purchase stocks of companies that they expect to grow in value. The funds will then sell the stocks for a profit. This is a riskier option with higher fees since the funds buy and sell volatile stocks and make a larger number of trades.
- Value funds purchase undervalued stocks and hold onto them as their value grows. This is a long-term investment strategy. Value stocks often pay dividends so the investor can make money in more than one way. The fees are often lower too.
- Index funds: This is a fund that works to match the growth of a specific index, such as NASDAQ. These fees will be the lowest because they make relatively few transactions.
- Blend Funds have a mixture of stock types. That means lower risk, but also lower potential for profit.
- Sector funds. These focus on specific types of companies. That could be defined by size, as with large cap or microcap funds, by industry, as with energy funds or technology funds, or even markets, as with funds dedicated to emerging markets or specific national markets.
- Bond funds. These funds hold packages of bonds, often diversifying their holdings to reduce default risk.
- Money market funds are income-generating funds holding packages of short term debt.
- Balanced funds hold a mixture of securities, often including both stocks and bonds.
- Commodity funds invest in commodity futures, and are a good choice for investors who want commodities in their portfolio but don’t want to deal with the intricacies of commodity trading.
All of these types have advantages and disadvantages. You’ll need to choose the ones that work best for you.
What is an ETF?
An ETF or Exchange Traded Fund is very similar to a mutual fund. In each case, investors pool money and place it under the guidance of fund managers, who select investments for the fund.
The difference between a mutual fund and an ETF lies in the way each one is traded.
Many ETFs are passively managed. They have a fixed set of holdings, often designed to track an index, and the holdings rarely change unless the composition of the index follows. Mutual funds may be managed in the same way, but many mutual funds are also actively managed, buying and selling holdings on a regular basis.
How You Can Earn From Mutual Funds?
Mutual funds can produce gains in two ways: gains from distribution and gains from an increase in fund value.
Gains from an increase in fund value are realized only if you sell your holdings in a fund. When mutual fund managers choose good investments, the value of the stocks and securities inside will increase. If the fund value has increased since you bought it, you can sell the fund shares you own and make a profit. Of course fund value can also decrease.
The Diversification Advantage
Diversification is a core principle of sound investing. It goes back to the old adage about not putting all of your eggs in one basket.
When you invest in just one stock or security, you’re exposed to a lot of risk. If the stock does well, you can earn a large profit. But what happens to your money if something unexpected happens, and that stock crashes?
Diversification controls risk by spreading your money out among multiple asset classes and multiple assets within those classes. This limits your vulnerability to fluctuations. If one asset does poorly, you have the ability to recoup some of your losses from the other assets rather than losing it all.
Mutual funds are one of the best ways to diversify your portfolio, especially if you have a limited amount to invest. Because each fund holds many different stocks, your investments are diversified from the start. The diversification factor is one of the key advantages of mutual fund investing for beginners.
The Benefits of Mutual Funds for New Investors
There are many reasons why mutual funds are the preferred investment vehicle for new investors. The benefits of mutual fund investing for beginners include:
- Simplicity: Mutual funds are easy to work with. If you have no experience with investing, mutual funds are a good place to start.
- Ease of purchase: Many companies offer mutual funds and ETFs can be bought through any online broker. Most tax-advantaged retirement accounts offer fund options. This makes it easy for even a new investor to open an account and start investing in this option in no time.
- Diversification: mutual funds allow for immediate diversification. This limits the risk that a new investor takes on, making it easier for them to learn about investing and earn money without having to worry about a big dip in a key holding.
- Variety: Mutual funds are available in an almost infinite variety of types and specialties. Whatever investment focus you want to establish, there’s a fund to fit it.
- Affordability: Many new investors like mutual funds because they are affordable. Many have low minimum purchases and you can establish a diversified portfolio with a single relatively small investment.
- Professional management: mutual funds are managed by full-time professional investment managers. If you don’t have the knowledge or the time to manage your own portfolio, that’s a big advantage. Effectively you are hiring a manager to handle your investments for you.
For new investors, the logic behind starting with funds is almost overwhelming.
Drawbacks of Mutual Funds
No investment vehicle is perfect, and there are a few drawbacks to choosing mutual funds.
- Fees. Mutual funds charge management fees, and may have sales charges, advertising fees, and other expenses. Aggressively managed funds usually charge higher fees. Look for each fund’s expense ratio, which summarizes all of the fees, before selecting a fund.
- Tax timing. You will not be able to choose when you want to take payouts from your fund, which could make it difficult to manage your income for tax purposes.
- Slow execution. No matter what time you place a mutual fund trade, the trade will be made at the closing price NAV. If a fund’s value is falling you may not be able to sell immediately.
- Non-productive assets. Every mutual fund has to keep a substantial amount of cash on hand to make new purchases and to meet obligations to investors who sell the fund. That money is not earning any return.
- Potential for management abuse. Managers may make mistakes or abuse their power, to the detriment of fund holders.
- Lack of insurance. The FDIC does not insure fund investments, making funds inherently more risky than savings vehicles.
Investors can compensate for these risks and deficiencies by carefully assessing funds before making a selection.
How to Choose the Right Mutual Funds
As with any investment, the key to successful mutual fund investing is selection. No mutual fund or mix of funds is “best”: you need to choose the fund or funds that will suit your personal investment objectives and style. Here are some factors to look at.
- Your risk tolerance. As with most forms of investment, your risk tolerance is a key factor in fund selection. You’ll need to assess your risk tolerance and select funds that fit it.
- Your investment objectives. Are you looking for long-term capital growth? A steady return on investment? A mix? Your goals will define the type of funds you select.
- Your preferred management style. Are you looking for a passively managed fund that moves with the market overall? Or are you willing to face the higher costs and risks of funds that try to beat the major indices?
- Fees and costs. Once you narrow your choice down to a category of funds, you’ll want to look compare the costs of the leading contenders in that category. Be sure that you’re looking at a complete cost assessment.
- Performance record. There’s no assurance that past performance will be repeated, but a review of past performance will give you an idea of how well the fund’s managers’ choices have done in the past.
- Ratings. A number of investment rating services rank mutual fund performance according to various criteria. You’ll want to keep an open mind – their criteria might not match yours – but ratings and collections of ratings can be a useful source of information.
These criteria should narrow your choices down and streamline your selection process.
The simplicity and immediate diversification funds offer makes them a great starting point for beginners, and even veteran investors will often have a substantial fund allocation in their portfolios. Whether you’re looking for a low-fee index fund as your first investment, a package of funds for your IRA or 401(k), or a specialized fund to give you diversified exposure in a key market sector, mutual funds will probably be a permanent part of your investing career.
Do you have any questions about investing in mutual funds? Let us know in the comments below!