Just what is a mutual fund? What are the advantages? What are the risks? One way to view a mutual fund is as a “bucket” that contains many types of investments. They may be risky, low risk, or a blend of both. Most mutual funds contain a mix of stocks, bonds, and other investments. The mutual fund managers typically invest the money clients provide in a wide range of securities based upon the goals of the fund at issue. The individual goals and risk inherent in the fund need to be looked at prior to investment by the client to be sure they meet client’s goals and risk tolerance. After purchasing a fund each individual investor owns shares of the bucket, not shares in the actual stocks and bonds. Each bucket is different based on what is inside, which is why there are so many options when it comes to investing in mutual funds.
There are several ways to make money on mutual funds.
- Income can be derived from the dividends and interest on stocks and bonds. This income is then passed on to investors through an annual distribution.
- If some of the holdings in the fund have increased in value, the fund can then sell some of its holdings, resulting in a capital gain which is usually passed on to investors through an annual distribution.
- If there is an increase in value of the holdings in the fund, the investor can then sell shares of the mutual fund, resulting in a profit.
Advantages
- Management. One of the biggest advantages of mutual fund investment is that a professional is managing your investments. Most small investors simply don’t have the requisite time or experience to manage the many stocks and bonds of a portfolio. Of course, there is a cost for this. That cost needs to be looked at and factored into the initial decision regarding which fund to buy based upon the client’s needs. We will address this and other possible disadvantages further in Part Two of this article next month.
- Diversification. Another advantage of mutual fund investment is that by investing in a share of the bucket that holds many different stocks, bonds, and other securities, individual investors can be at less risk because their money is more spread out, or diversified into several asset classes. The more varied the securities in the bucket, the less the bucket is affected by the individual performance of one or two of the holdings. Of course, this may or may not be true depending upon the mutual fund purchased, and again this is something to be checked prior to purchase. The “bucket” could also hold investments that are not as diversified as the client may assume them to be.
- Lower costs. Mutual fund companies engage in large transactions when they are buying and selling. In theory, this should lower the transaction cost to the investor. However, all the costs of the fund need to be pulled from the prospectus to be sure of all the costs of the fund, including all recurring costs of management.
- Liquidity. Shares in mutual funds can generally be converted to cash at the current market rate.
- Simple and easy. Just about every bank offers its own mutual funds, with the minimum required to invest often being relatively small.
While there can be many advantages to understanding and investing in mutual funds, there can also be risk involved, risk that is too often kept from the general public, or buried deep within a prospectus that clients often fail to read at all. In Part Two, we will discuss the various risks associated with mutual funds and what investors should know before they invest.
If you think that you have been the victim of investment fraud, contact Daniel Carlson at the Carlson Law Firm today for a free consultation at 619-544-9300.
