Thinking of investing in mutual funds? It’s critical you know the advantages and disadvantages of investing in a mutual fund over a single stock.
Now that we’ve covered how mutual funds work, let’s talk about the pros and cons of mutual funds. While it’s true that with a mutual fund you will have professional money management, instant diversification and liquidity, it’s important to understand that it comes with a cost. Mutual Fund companies have to make money, of course, and they do that by taking some of the funds’ assets to cover their salaries and other expenses.
Advantages of Mutual Funds
- Professional management. Mutual Fund managers are professionally trained and experienced, constantly watching and managing their fund. Remember, though: the guy on the other side is not Warren Buffett. He might come close, but he’s not Warren.
- Instant diversification. Since one of the primary rules of investment is to diversify portfolios, a mutual fund can be a simple and successful way to accomplish this goal. With one investment, you will own shares of stock in many corporations. A mutual fund portfolio combines a variety of stocks, bonds, commodities and cash, mutual funds are, by nature, diversified. If one stock or asset goes down, there will be others that compensate for it. This just means that the potential for losses is spread out conservatively.
- Liquidity. If you ever want to get out of a mutual fund, all you have to do is instruct your broker or financial advisor. They can sell it immediately. Normally, the funds take a day to come back into your account, but that’s not so bad. Comparatively, individual stocks would take much longer to liquidate.
- Match your style. You can find a mutual fund that matches almost exactly what you are looking for from an investment. This could be related to both your risk tolerance and your investment horizon.
Disadvantages of Mutual Funds
- Management Fees. Mutual fund companies have to pay salaries and marketing expenses and they always get paid FIRST before the investors/owners get paid! Management fees are one of the key metrics to watch out for as an investor because they can quickly and devilishly eat into your profits over time. Do higher management fees correlate to higher returns and better performance? As it turns out, the answer is NO. In fact, many studies have been done that show higher fees generally correlate to lower performance.
- Locked in Clause. There are two different mutual fund structures – one allows you to go in and out at any time. The other one is locked in for 5-7 years. With this one, if you try to take your money out earlier, you’ll get charged for it. Make sure to ask your financial advisor which type you are investing in.
- Wasted Cash. Because people occasionally want to withdraw their mutual funds, there must always be funds available – in cash – for payouts. When money’s in cash, it’s not collecting interest. Since this comes from a portion of the investment funds, it means it doesn’t collect any interest for you. That amount of cash is better off sitting in your bank account.
Mutual Fund Charges.
Mutual funds charge fees when you redeem your money. There are also “operating expense” fees. This is a percentage of what it costs to run the fund. Let’s say you invested $10,000, and the operating fees are 2%. This means that you are effectively paying $200 every year in operating charges.
Buying Individual Stocks Versus Investing in Mutual Funds
As a newer investor, you should also be aware that you can save some research time by investing in mutual funds instead of individual stocks. Mutual funds contain a mix and diversity of stocks in which you will spread out one investment into many small blocks of shares.
Mutual funds and ETFs (exchange traded funds) have been available since the mid-1970s (mutual funds) and early 1990s (ETFs), attracting billions of investment dollars. An easy way for investors to diversify their portfolio without doing extensive research on individual companies and stocks, they are attractive to the casual or, perish the thought, lazy investor. Over time, mutual funds, ETFs, and Index ETFs (funds specializing in and tied to an industry index) have performed quite well.
You should understand, however, that few of these funds have outperformed the market in general. More than 90% of mutual funds fail to beat the S&P 500 index (a compilation of the 500 biggest U.S. stocks) every year, making mutual funds an expensive way to pay for diversification and risk management.
One of the many reasons that funds cannot beat the markets is because of the obvious expenses that they have. They buy ads in magazines and on TV. They have large legal and accounting expenses. And they have to mail you your statements every month. Some mutual funds charge rather large fees for trades and/or management. Always learn about these fees before you decide which mutual fund is best for you. In most cases, these fees reduce your return by 0.50-2.00% and make investing in individual stocks by yourself the logical choice.
One of the myths about the stock market is that you get what you pay for and that by paying big fees, you’ll get a big return on your return. That simply isn’t true and, in fact, the opposite is more often true: low fees and no expenses usually lead to the biggest returns on your money.
The Bottom Line: Why Invest in Mutual Funds?
As with anything in the stock market: there are no guarantees.There are certainly pros and cons when it comes to mutual funds. Mutual funds are based on stocks and other investments that can go up or down. Contrary to what the ads seem to suggest, performance is not guaranteed with a mutual fund. All we have is past performance to make our decisions.
On the other hand, just because a mutual fund loses money one year does not mean it will lose money every year. If you have absolutely no stomach for risk, then maybe stay away from mutual funds. But – if you believe in the financial system, there’s not much harm in trying it out. After all, investing in a mutual fund is way less risky than going for a single stock.
The stock markets of the world are a wonderful opportunity to increase your wealth. However, you must bring your brain and knowledge with you when you enter these waters. It’s important that you learn all that you can about the market: how it works, market cycles, how it faces roadblocks and problems, and how you should react to the highs and lows that eventually occur. Our Putting Your Money in the Market course will help you with that.
Be strong, be confident, be smart, hopefully be lucky – and be profitable!
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