MONEY TALKS - A mutual fund is a professionally managed investment vehicle that pools money from individual investors to purchase securities. In other words, investors are putting their money together with other investors to purchase a collection of stocks and bonds. While there are many reasons to invest in mutual funds, there are three major advantages that mutual funds have over individual stocks.
Diversification - The first advantage mutual funds have over individual securities is the ability for an investor to create a diversified portfolio at a very reasonable cost. Creating a balanced portfolio using individual stocks can be very costly due to the transaction costs involved. With mutual funds, for a minimal investment, an investor can gain exposure across broad market segments. In fact, most mutual funds have hundreds or even thousands of individual securities. By creating a balanced portfolio you can reduce or essentially eliminate the unsystematic risk or “diversifiable risk” within your portfolio. This doesn’t mean that you can eliminate all risk, as all investments are subject to risk. What it means is you can reduce the risk associated with a particular security or industry. For example, if you owned stock in a single automotive company, your investment could be at risk if the company was improperly managed, the competition prevailed, or the union workers went on strike. By investing in a diversified fund you are protecting yourself from the risks associated to a particular business or industry.
Professional Management - Another major advantage mutual funds have over individual securities is they are professionally managed. Most of us barely have time to eat breakfast, let alone dissect individual stocks. But fund managers have the time and expertise to properly research and analyze securities. Not to mention, managers often have their own support team of analyst to help research and to make buy/sell recommendations. However, fund managers are not free to invest in any security based on their latest whim. Each mutual fund has a specific investment objective that the manager must adhere to when deciding what securities to purchase. This ensures that the manager stays committed to the overall objective of the fund and not their personal feelings. Most importantly, fund managers are generally compensated based on the performance of the fund, so they are highly motivated to go above and beyond their benchmark. Before investing in a mutual fund, you should look at the tenure of the current manager as well as the fund’s performance during that same period.
Simplification - Last but not least, mutual funds simplify the investing process for individual investors. With one single purchase, an individual can create a diversified portfolio. Creating a diversified portfolio using individual stocks could take tens or even hundreds of transactions. This is very time consuming and could involve a lot of transaction costs. Furthermore, unlike stocks, when you invest in mutual funds you can buy fractional shares. This means that you can invest a specific dollar amount in the fund. Trying to investing $1,000 in individual securities without over or under spending can be a daunting task. On the other end of the spectrum, mutual funds are very liquid and extremely easy to sell. With a push of a button shareholders can sell their holdings back to the fund at the close of every trading day.
Savvy Investing - The diversification, professional management, and ease of investing make a compelling argument to include mutual funds in your investment portfolio. That being said, mutual funds, like any other investment, are not without risk. Although diversification does reduce your risk exposure, it does not guarantee profits or prevent losses. While mutual funds are a great investment vehicle for most consumers, not all mutual funds are great investments. Some mutual funds have a hidden sales charge, or “load,” as well as marketing fees that can be avoided through savvy investing. I would advise talking with an experienced investment advisor or financial planner to understand the risks involved. The sooner you do, the faster you can take advantage of the benefits mutual funds have to offer.