Mutual funds are one of the most popular financial vehicles for individual savers. Moreover, they are often the first tool of choice recommended by financial advisors for people starting to think about life-long savings plans. For this reason, it is essential to know the basic pros and cons of mutual funds in advance. Essentially, mutual funds are a helpful way to diversify risk and to invest in a wide assortment of companies at minimal cost; however,
– Pros of Mutual Funds –
The most important beneft of buying into a mutual fund is that it allows you to diversify your investments. Diversification is extremely important in investing. Purchasing bonds or stocks in a single company means you could lose everything if that company collapses (or lose a lot if its stock price falls). However, mutual funds purchase shares or bonds in many different companies simultaneously, reducing the consequences if a single company or a few companies fail. When you buy into a mutual fund, you are essentially buying a share of that overall portfolio – so when the overall stock portfolio goes up, your investment goes up, even if a few companies decline or even go bankrupt. Personal financial advisors will often counsel diversifying further by buying into several mutual funds at once, so that even when one or more mutual funds perform poorly, your investment in other funds may increase.
This points to a second key benefit of mutual funds: the capacity to buy into a large number of companies at minimal cost. You could, in theory, go out and buy shares in all of the companies that a given mutual fund does, and hold them personally. However, this would be far more expensive than simply buying shares of the mutual fund. Most mutual funds do require that you invest a minimum sum at a time, but this amount is generally no more than hundreds or (uncommonly) thousands of dollars.
Another benefit you will gain from investing in a mutual fund is that you do not have to make the decisions about which stocks to invest in personally. Instead, a mutual fund has a professional manager who makes decisions about when to buy or sell the various shares or bonds which the fund holds. Ideally, that manager will be able to make better decisions than the people who invest in the fund, who for the most part are not professional investors. This manager, and the fund itself, are regulated by the government in most countries, so that they have to conform to certain rules and expectations regarding good conduct.
– Cons of Mutual Funds –
As with most investments, the most important drawback to consider with mutual funds is that they are still an unsafe investment, despite the fact that they are more diversified than individual stocks and that they have a professional manager who will attempt to stave off the worst of the losses. Particularly in a year when the stock market as a whole falls, your mutual fund’s value could fall, and the value of your investments could therefore fall as well. There is always some level of risk in investing.
In addition, when you invest in a mutual fund, the fund must raise enough money from its investors to pay its management personnel and cover expenses. Some funds will levy fees when you buy into the mutual fund (“front-loaded”), or when you sell out of the mutual fund (“back-loaded”). Almost universally, however, all mutual funds will levy an annual fee as a percentage of the share’s value, known as the Management Expense Ratio (MER). The MER varies by fund and (on average) by country, but as a general rule you can expect to lose 1-2% each year to the MER.
For this reason, many advocates of a do-it-yourself style of personal financial management today advocate buying into index funds, or passively managed mutual funds, rather than the more common actively managed mutual funds which are typically recommended by professional financial advisors. Index funds, instead of regularly buying and selling shares of target companies, instead buy and hold all companies on a large index, such as the S&P 500 in the U.S., or the S&P/TSX 60 in Canada. An index fund has no professional manager to adjust investments in the event some companies perform much better or worse than expected, but some advocates of index funds claim that, because of the far lower MER (typically a fraction of a percent), index funds can perform as well as or better than most traditional mutual funds. Still, in general, most people with little knowledge of investing may still feel more comfortable investing in traditional mutual funds recommended by a financial advisor.
Overall, most people with an interest in personal finance agree that, given the pros and cons of mutual funds, they are still a relatively safe and useful form of investment for people who simply want to save money for retirement and watch their investment grow over time.