Total US mutual fund assets in 2021 were approximately $34.15 trillion. Why do many investors choose mutual funds over other investment options?
Diversification is the cornerstone of a strong investment portfolio, and mutual funds help investors achieve this goal. Mutual funds invest in a variety of securities, including bonds, short-term debt, and stocks. An individual investor buys into a mutual fund, then the fund manager makes ongoing trades for the ultimate profit of the investors.
Keep reading to learn more about how mutual funds work, whether they’re right for your portfolio, and how to get started.
What is a mutual fund?
A mutual fund is a specific financial vehicle that pools investments from shareholders to invest in a variety of assets, including bonds, stocks, money market instruments and other assets.
Mutual funds are managed by professional money managers, giving individuals access to managed funds without the need for significant capital. Instead of working for you individually, the mutual fund manager combines the assets of all investors and makes strategic transactions to improve shareholder value.
However, as with any investment, investors should carefully consider the fund’s history, prospects and manager before making a purchase.
Are mutual funds a good investment?
Mutual funds can be a great investment if you do your due diligence before investing and if the fund fits your investment goals and risk tolerance.
Average mutual fund returns vary by category, with U.S. large-cap stock funds posting a three-year return of 23.84 percent through 2021, compared with 3.02 percent for short-term bond funds over the same time frame.
Understanding the pros and cons of mutual funds can help you decide if they are the right financial vehicle for your portfolio.
Benefits of mutual funds include:
- The advantage when a professional manager constantly evaluates and analyzes the mutual fund portfolio to add value.
- Diversify various assets by making a single investment. Each mutual fund has a prospectus that defines how it makes investment decisions and which asset classes it targets.
- Strong cash flow as investors can redeem shares any day for current net asset value plus any redemption fees.
Are there any downsides to mutual funds? Some notable disadvantages include:
- There are no guarantees on returns, and like any other investment, they can still lose value.
- Dilutive, meaning that a previously successful fund receives cash flow and the fund manager struggles to find suitable investments with new capital. Dilution can cause the wrong kind of diversification that can harm the mutual fund.
- Only end-of-day redemptions, making it a poor choice for those looking to day trade. Mutual funds are typically considered a more long-term investment.
Mutual funds can be a good choice for investors who want to take a more passive approach to increasing value. You secretly put money into the fund while the money manager manages everyone’s investments to add value. The fund manager himself can take an active or passive role. A passive mutual fund aims to replicate a broad benchmark such as the S&P 500 (INDEXSP:.INX), while an active mutual fund focuses more narrowly on separately managed investments.
How much of your portfolio should be invested in mutual funds? Many investors adhere to the 5 percent rule, which states that you should allocate no more than 5 percent of your portfolio to one investment security.
However, since mutual funds include many securities, you can keep more than 5 percent in mutual funds while following this guideline. Ultimately, it depends on your risk tolerance and investment goals.
How to invest in mutual funds?
You can invest in mutual funds with a broker or directly through a fund company such as Fidelity (NYSE:FNF) or Vanguard (NYSE:VOO).
Most brokerage accounts used to buy stocks and bonds are available for mutual funds. If you are setting up a new brokerage account that focuses on mutual funds, thoroughly research which funds are accessible, any associated fees, and the future of the fund. Your brokerage account will typically have a separate interface for buying mutual funds, or they may be integrated into a standard trading dashboard.
There are a few key considerations when choosing the right mutual fund such as:
- Looking for passive or active mutual funds?
- How much of your portfolio do you want to invest in mutual funds?
- What are the fund charges?
- What type of mutual fund best suits your goals? Funds may target a variety of securities, which will be clearly described in the prospectus.
- Does the mutual fund pay dividends?
While top mutual funds have 10-year annualized returns ranging from 7 percent to 11.9 percent, short-term returns are much lower. So, look at historical performance and focus on long-term results while choosing a mutual fund.
Typically, buying a mutual fund requires a flat dollar amount, such as $500. Other mutual funds can be traded at variable prices, just like stocks. Fractional shares are a growing trend that may be available depending on your broker.
Mutual funds with ETFs and stocks
How do mutual funds compare to exchange traded funds (ETFs) and stocks? There are similarities and differences to really understand before investing.
Mutual funds with ETFs
Both financial instruments allow you to buy many securities, but they have important differences. The main difference is that ETFs are traded like stocks, while mutual funds can only be bought at the end of the trading day. Another advantage is that most mutual funds are actively managed, while ETFs are easily managed. As a result, ETFs become a cheaper option.
Mutual funds and stocks
A stock is a single company in which you buy stock to make a profit or buy low and sell high. In contrast, mutual funds generally consist of stocks and asset classes of multiple companies.
Mutual funds are good additions to a well-balanced portfolio with a focus on long-term growth. However, they are typically not suitable for day trading, and are instead used to build a solid foundation for accumulating wealth over years or decades.
Be careful while investing in mutual funds and do your due diligence before buying. Read through the prospectus, understand all related fees and find out if it is passive or active. As with any investment, take your time to research all the moving parts before investing.
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