Mutual funds are investment vehicles that pool the money of many investors together to purchase financial assets. A fund manager oversees this money and invests it according to the fund’s stated investment objective. Mutual funds can be advantageous to investors who may lack the wherewithal or expertise to invest in individual securities. Mutual funds provide a level of diversification that is often difficult for the individual investor to achieve otherwise. Here is a quick look at how mutual funds work.
Mutual Funds and Investment Objective
A mutual fund’s investment strategy, or objective, is outlined in its prospectus. It is important to read a fund prospectus before investing to truly understand what you’re buying. It is also important to understand how the fund manager intends to achieve the stated investment objective.
Investment objectives may be categorized by the asset types and securities a fund owns. Some examples might be:
- Equity Growth Funds – may invest in common stocks
- Sector Funds – may own companies only in a specific industry or economic sector
- Global Funds – might buy stocks all over the world
- ESG Funds – could own companies deemed Socially Responsible
- Bond or Income Funds – may seek income-producing investments
- Index Funds – may track the performance of an investment benchmark
- Balanced Funds – might own both stocks and bonds
- Smart Beta Funds – may invest based on specific investment performance factors
What are the Advantages of Mutual Funds?
There are four distinct advantages of owning mutual funds. They are:
Instant diversification is an important advantage of mutual funds. A well-diversified portfolio requires that assets be spread out between many different securities. It is an important aspect of mitigating investment risk.
Owning mutual funds provides instant diversification because from the outset you are buying a structured portfolio, not an individual security. Mutual funds invest in a large number of securities, which mitigates the risk of loss inherent in any one of them.
Attempting to recreate this level of diversification on one’s own would require a level of investment capital, knowledge, and expertise that many individual investors do not have.
A second important benefit of mutual fund ownership is prompt liquidity. Shares can be redeemed every business day.
Another important advantage of mutual funds is their simplicity. Mutual funds make it easy to manage an investment portfolio because they offer turnkey solutions that can be aligned with your specific investment objectives.
The fourth advantage mutual funds offer is accessibility. Mutual funds provide access to professional investment management. They deliver comprehensive teams of research analysts, fund managers, fund administrators, professional traders, legal experts, tax professionals, and compliance experts all dedicated to deliver investment performance for the individual investor.
Mutual funds provide individual investors a professional investment management infrastructure that one might expect to be available only to large institutions or the very rich. Because mutual funds have relatively low investment minimums (some funds have no minimum investment requirement) they are available to nearly any individual investor.
Align Mutual Funds With Your Goals or Risk Tolerance
Mutual funds are not a panacea. They do not deliver instant wealth. Nor do they eliminate risk. Mutual funds have the same specific investment risks and returns as the underlying assets they own. Still, they may be appropriate investments to achieve specific investment outcomes.
For example, retired investors can create a portfolio of income producing funds. Younger investors looking to grow wealth can build a mix of growth funds. And those looking for a balance of income and growth might choose to include bond or income funds into a mix of equity funds.
In this way, mutual funds offer investors the opportunity to structure asset allocations that reflect their individual risk tolerance. And whatever the investment objective might be, mutual funds provide additional opportunities to increase your holdings.
Many mutual funds provide cash distributions that pass on to investors dividends paid by investments the fund owns. Other distributions pay out capital gains. Investors have the choice of taking these distributions in cash or reinvesting them in additional shares of the fund. Reinvesting increases the number of shares owned and may help compound future returns.
Some investors augment this with regular or “automatic” reinvestments over time. Where holding a mutual fund for a long time may help build wealth, ongoing reinvestment over time helps blend acquisition cost in a strategy referred to as dollar-cost averaging.
Dollar cost averaging is a process of regular and continual investment. You establish either a fixed dollar amount or a fixed number of shares that you purchase at regular intervals. This systematic approach to adding shares of a fund to your holdings typically means that you acquire them at different prices.
When the price is low your regular investment will cost you less (if you buy a fixed number of shares) or allow you to buy you more shares (if you invest a routine amount). When the price is high, the opposite is the case. Over time your acquisitions blend into an average price.
Dollar cost averaging can remove speculation about whether your investment was well timed, because you’re adding to it over time. It can also remove the emotional element of making a single large investment, since you make many smaller investments. All the while, you’re adding to your holdings. Of course, dollar-cost averaging does not guarantee a profit and does not protect you against loss in a falling market.
Don’t go it Alone
It is important to remember that, historically, investment returns have tended to pan out over time. Investors in any asset class or investment vehicle must be patient and allow their investments to produce results over various time horizons, some of which may span many years.
The patience necessary to be successful can be difficult. That’s where we can help. Our Member Service Representatives are available to answer your questions and can help you identify planning opportunities. Call them at 800.235.8396.