What are Mutual Funds?
Mutual Fund Definition
A mutual fund is a collection of stocks and/or bonds. Think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund.
You can make money from a mutual fund in three ways:
1. Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all income it receives over the year to fund owners in a dividend.
2. If the fund sells securities that have increased in price, the fund has a capital gain. Most funds pass on these gains to investors in the form of a distribution.
3. If fund holdings increase in price but are not sold by the fund manager, its shares increase in price. You can sell your mutual fund for a profit.
Mutual Fund Advantages
Professional Management - The primary advantage of funds is the professional management of your money. Investors purchase funds because they do not have the time or the expertise to manage their own portfolio. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments.
Diversification - By owning shares in a mutual fund instead of individual stocks or bonds, your risk is spread out or diversified. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can hurt you. A single mutual fund can own over 100 stocks in many different industries.
Economies of Scale - Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than you would pay personally on smaller and fewer transactions.
Liquidity - Just like an individual stock, you can get your money out of a mutual fund at any time by requesting that your shares be converted into cash. Purchases or sales of mutual fund shares are based on the price of the fund at the close of each business day also known as Net Asset Value (NAV).
Mutual Fund Disadvantages
Costs - Mutual funds are in business to make a profit. Expenses for mutual fund management are contained in the expense ratio, which is disclosed in the fund's prospectus. These fees are "hidden" in the share price of each mutual fund. It is important to compare costs when selecting a mutual fund as they impact the fund's performance.
Taxes - Fund managers don't take into account your personal tax situation. For example, when a fund manager sells a security it triggers capital gain tax. This happens even though it might have been more advantageous for an individual to defer the capital gains liability. Of course, the tax issue is not a factor in retirement plans since your earnings are tax-deferred.
Portfolio Manager Performance - Not all mutual funds are created equal. Before selecting a mutual fund, it is important to do your homework. How has the mutual fund performed compared to its peers? A poorly performing fund can take a bite out of your retirement balance.
Dilution - It's possible to have too much diversification. Because funds have small holdings in so many companies; great gains in a few investments often don't make much difference in the overall return. Also, successful funds often get too big. When money pours into funds that have had strong success in the past, the manager may have trouble finding an investment for all the new money.