Why Consider Investing In Mutual Funds?
Mutual funds are an extremely popular investment vehicle among individual investors, and do have a number of big advantages over going it alone. Like any investments, there are pluses and minuses to mutual funds, and the degree that one should invest in them depends to a large degree on one’s situation, preferences, resources, and goals.
Mutual funds pool the financial resources of many investors and offer the advantage of professional management as well as lower transactional costs. Bigger is better in some ways though and not as good in others, but overall, this is a great way to invest generally.
Large investors can hire dedicated managers of their portfolio, although one does need a large portfolio to make this cost effective, otherwise the management costs would be overwhelmingly high. So this is way out of reach of the average investor, but he or she may still want to benefit from having their assets managed by a money manager.
Since the assets of all the people who invest in a mutual fund is pooled, the totals add up to anywhere from very large to huge amounts, and the pooled assets can be managed by fund managers at not only acceptable costs, but very desirable ones on a percentage basis.
Another big advantage of mutual funds over individual investing is the fact that they can trade in an enormous number of things, hundreds or even thousands of issues, something that would not be even close to possible on your own. The billions of dollars in assets that funds hold simply give them much more buying power than individual investors could ever aspire to.
Simplifying The Equation
So scope and breadth becomes greatly enhanced, which leads to all the potential for all the diversity you could ever want. Diversity can definitely be an advantage, as it does spread out certain risks, although the degree of this depends on the makeup of the fund.
For instance, the world’s largest fund these days buys all the stocks on the S&P 500, so you own a piece of all 500 stocks when you buy this fund, and this is a huge fund, with net assets of almost $200 billion. So you don’t worry about a particular component having trouble, and people do see that as an advantage, and in some ways it is.
So with that much in assets, transaction costs are kept to a minimum per dollar held in it, and in fact passively managed funds like this have the lowest percentage of costs to value than anything you’ll ever see in the financial world.
These are called index funds and they just hold everything in an index in a given proportion, and there isn’t even any thinking involved in it, so they are very inexpensive to manage. They are set up to mirror the indexes they follow, which is very easy to do.
There is a feeling out there among many investors that you can’t beat the market so to speak long term, which actually depends on the size of the portfolio, and the smaller the portfolio, the easier this is to do, but it’s much more difficult with huge ones.
A Matter of Fit
Index funds aren’t the be all and end all of mutual fund investing though, and there are countless funds out there which don’t follow indexes, but follow other investment strategies, and the whole idea of all of this is to have funds that best match the strategies that investors have, which can differ a lot.
If someone has a very long term horizon though, and is looking to minimize their risk versus some other strategies that may be more specific to certain sectors or regions or whatever, then investing in index funds may indeed fit one’s investment preferences quite well indeed. Indexes are very well diversified and you basically ride the market wave, which over the long term has proven to be very reliable.
So time horizon is part of it, but some investors may prefer a more actively managed approach even though they may have a long term horizon, focusing more on what’s hot and what’s not, and trading more as well.
It’s all about balancing risk and return here, and this is where the preferences and goals of investors really come in, and the less diversified an investment is, the more risk there will be, but not necessarily much more risk.
The performance of actively managed funds come down to the skill of the fund managers, and the better ones will outperform the less skilled ones, but we do have ways to differentiate this, and the biggest thing people look at is the fund’s past performance.
Getting a fund or a selection of funds to best fit an investor is also very important. So we need to both be selecting good funds and also ones that fit the goals and risk tolerances of the investor.
People can and do select their own funds, but they do need to be careful with their selections, and often times these selections are done in consultation with an investment advisor, who will use their expertise to not only recommend the good ones, but to ensure that the selections are appropriate for the investor’s circumstances.
The 3 Main Classes of Mutual Funds
Due to the massive popularity of mutual funds generally, investors are faced with a myriad of choices of which ones to invest in, and this variety is not just among similar funds, it is also among different types with different investing strategies and objectives.
While people usually think of mutual funds as investing in equities, the stock market in other words, there are mutual funds for pretty much every type of investment. There are three main classes of mutual funds, growth funds, income funds, and money market funds.
Growth funds, which include equity funds, have their main goal as being capital appreciation, the stocks in it going up in value over time for instance. Income funds focus mostly on dividend payments, and are dominated by bonds, although other forms of investment that deliver their value primarily by income may be included.
Income funds have less potential for growth but are less risky than income funds. The type of fund with the least risk, as well as the least potential for growth, is money market funds. They invest in short term financial instruments which are far less volatile than other investments, such as treasury bills, but are much more stable as well and therefore produce more reliable and predictable returns.
Seeking The Right Balance
Mutual fund investments look to not only seek the desired amount of diversity in the fund itself, within a certain asset class, they also seek to strike the right balance between asset classes and types.
So someone may want a certain diversity in an equity fund, with a lot of different stocks in it, across several industry sectors. One may also want to invest in a bond fund which holds a wide diversity of bonds to spread the risk that way.
However, one of the biggest risks in investing is market risk, where markets move together, and this happens in both directions, but it’s the downward direction that tends to concern investors, since the overwhelming majority of mutual funds are long the market, in other words betting on things going up not down.
Investors, and funds, may seek to have various amounts of their portfolios held in cash, not invested in other words, and may move more or less to cash as conditions dictate. This actually happens to a pretty large extent at times and is a big reason why these markets have so much market risk, because money gets moved out the market and is placed elsewhere in times of market uncertainty, which drives the value of the market down, and can do so considerably.
Investors will also use different strategies as far as the percentage of their assets held in the 3 major classes of funds, depending on the level of aggression sought. Those with the least risk tolerance may hold all of their funds in a money market fund for instance, those with the most risk tolerance may hold everything in growth funds, and others may seek some sort of appropriate mix of the 3 to suit their needs.
Others may invest in hedge funds, which are primarily set up to balance off these risks, particularly market risk. Hedge funds tend to do better in general market downturns, and may hold short positions as well as investing in things like gold which do well in downturns as people invest more heavily in these things when the market goes sour so to speak.
One may hold these hedged investments when they are speculating that things may go down, or they may hold them simply to offset the risks of their position, and derivatives such as futures and options primarily serve as hedges, although all of these things can be speculated with as well, as is the case with just about any investment.
There are definitely some real advantages to investing on your own, and contrary to what a lot of people think, you can beat the market with these, you can beat the funds, and trading smaller and with less issues does allow one to enter and exit positions much more easily, due to the much smaller volume involved compared with funds.
So individual investing can be like a speed boat, compared to a large ocean going ship of funds, which take a long time to turn around, but if you’re going to operate a speed boat, you are going to have to be skilled in doing so, otherwise you may be better off with safer and more stable options with an experienced captain at the helm.