Pitfalls of Mutual Funds

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The pitfalls of mutual funds

Just like any other form of investment, mutual funds also offer their balance of advantages and pitfalls. The common sense investor should always be aware of the potential downside to any investment medium. If you have plans of investing in mutual funds, keep these pieces of advice (and pitfalls to avoid) in mind.

There is real danger of overdiversification

Diversification is a good attitude when it comes to successful investing but there is a danger when mutual fund investors go overboard and overdiversify. Diversification aims to reduce the inherent risks that are associated with holding a single security or type of fund. Overdiversification involves two things. First, it occurs when an investor gets many funds that significantly overlap each other’s holdings thereby not really receiving the benefits of risk reduction given by diversification. Second, overdiversifcation can result in a drag on your overall return. By having too many poor-to-mediocre funds, the investor loses out on the return potential of a few well-managed funds.

It should also be pointed out that buying mutual funds does not automatically mean that you have diversified your investments. If you have funds that concentrate only in a particular market sector or region then you are still relatively at the same amount of risk.

The danger of blind diversification

One of the most pervasive errors in the investment industry is the view that you absolute must diversify across industries and asset classes. Many mutual fund managers buy into this philosophy. In fact, the whole phenomena of Index Fund investing is a reflection of this view.

At The Common Sense Investor we think this philosophy results in watered down returns and unintelligent investment practices. Your mutual fund should employ a strong investment philosophy that takes advantage of the fact that good companies will, more often than not, use your money wisely. But if you’re not seeking out good companies with your investment money, then who knows how your money’s being used.

The danger of passive investing

When you invest your money in a mutual fund, you are entrusting your money to a particular investment philosophy (either a manager, an index, an asset class, etc.) However, there is a danger that in entrusting your money to someone else, there is also a corresponding tendency to put blind faith in their ability to perform. The common sense investor needs to actively monitor the performance his funds and the investment philosophy that they employ.

Mutual funds give fluctuating returns

Mutual funds are like other investment options in that they do not offer a guaranteed return. There is also the slim possibility that the value of the mutual fund you bought will depreciate. Mutual funds also experience price fluctuations along with the stocks that make up the fund, not like bonds and treasury bills, which are more or less fixed-income products. The good news is that there are proven and consistent methods for using mutual funds to outperform the return of bonds and cash investments. But it is essential to research the fund you will be investing in. Just because a fund manager will be overseeing the fund it does not mean that it will be a strong performer. Rather, the long-term returns from a fund are a direct result of the fund’s investment philosophy: so choose a good one

Always remember that mutual funds are not guaranteed by the US government. This means that in the case of dissolution, you will not get anything back. This against reinforces the need for investors to do their homework and pick a consistently strong, well-managed fund with a long track record of superb earnings.

Money sitting around and not working for you?

Mutual funds, as you well know, accumulate and pool money from thousands of investors. This means that everyday investors are putting in and withdrawing money from the fund. In order to maintain this practice they have to keep a large portion of the money as cash. But having that amount of money is lying around, although great for liquidity, is not that good considering that this money could be used to work for the mutual fund and thus ultimately more advantageous for everyone. Look for funds with low turn-over and a low proportion of cash to stock.

Mutual funds can be costly

Mutual funds already provide investors with professional management. But this comes at a cost. Funds, in order to maintain its service, will have to charge different fees that would ultimately reduce the overall payout to investors. What’s more, the fees are charged to investors regardless of the performance of the funds – so in times where the fund is underperforming, the fees might only further magnify the monetary loss.

Conclusion

Having reviewed the various disadvantages to and potential pitfalls of mutual funds, we believe that mutual funds can and should be an essential component of the common sense investor’s overall investment plan. The key point throughout is that you have to take an active approach to mutual fund investing: only choose funds that have consistently strong long-term performance with a solid investment philosophy. And never forget to actively monitor each fund’s performance at least once a year.