The Benefits of Mutual Funds
Ever since they were formed, mutual funds have been a favorite investment choice for the average investor. Mutual funds are simple, cost-effective and they offer a level of diversification that one simply does not get in an individual stock. With mutual funds, you entrust your money with a good financial professional who should in turn use an intelligent investment strategy to pick stocks of good companies at reasonable prices. Below, we go into detail about some of the primary benefits of mutual funds and how they fit into the common sense investor’s strategy for building wealth.
Be warned: not all mutual funds are created equal. The common sense investor needs to seek out those mutual funds that are run by established managers with consistent track records and solid investment strategies.
Getting mutual funds gives you professional management
Buying mutual funds also means choosing a professional money manager who will use the money you have invested to buy and sell stocks. So rather than you doing the research for making investments a mutual fund’s money manager will do it in your behalf. This doesn’t get you completely off the hook, though! You still need to do research on the professional money manager and mutual fund that you pick. Don’t get stuck with a mutual fund dud. Make sure that the mutual fund expenses are low, that the money manager has a proven, consistent track record (don’t fall for a one year anomaly that artificially inflates his performance), and a sound investment philosophy.
Mutual funds offer asset diversification
There is one rule that investors of all persuasions have taken to heart is selective asset diversification. This simply means mixing the investments in a portfolio as a way of managing risk. There is much higher risk that one company will do poorly, then there is that 20-30 well-chosen companies will do poorly. Keep in mind that diversification is worthless if you diversify into a lot of bad investments. Still, there are some basic principles of diversification to keep in mind. As already mentioned, you can diversify into different companies, but you can also diversify into different economic sectors (e.g. technology, manufacturing, industrial, energy, etc.) and asset classes (e.g. large company, small company, foreign company, etc.). Regardless, always choose well-run companies at reasonable prices.
To illustrate this point, an investor decides to buy stocks in the manufacturing sector but also offsets that exposure by buying stocks from the industrial sector as a way of reducing the actual impact of the investment. In other words, if the stocks bought in the manufacturing sector depreciated, your other stocks would generally remain unaffected – independent of the movements in the previous sector’s market. To truly achieve the benefits of a diversified portfolio, you must buy stocks with different capitalizations in different industries. The Common Sense Investor does not recommend diversifying into bonds or cash because 1) they simply do not meet the objective of reaching your highest possible return and 2) companies work for their shareholders, not their bondholders.
Doing the research and developing a strategy for diversification can be tedious, time consuming and definitely costly.
But with mutual funds, the diversification is more or less built in. You get the instant diversification and asset allocation but without having to shell out a big amount of cash. Just make sure that you pick good mutual funds. There are a lot of duds out there.
Mutual funds offer good economies of scale
When investing in mutual funds you can take advantage of their buying and selling size – and this can reduce the transaction costs to your benefit. Buying mutual funds allows you to diversify without having to pay a lot of commission charges.
Mutual funds are offered at lower denominations
Investors usually don’t have the exact amount of money to buy round lots of securities. A round lot of stocks would usually fetch for a high price. But it is easier to purchase mutual funds because it is usually offered in smaller denominations. This means investors with limited funds don’t need to wait to save up to afford getting into an investment opportunity.
Mutual funds are liquid
Another advantage of mutual funds is that you can get in or out of this investment relatively easily. You can sell mutual funds at any time without any penalty because they are liquid like regular stocks. The price of mutual funds is determined at the end of any trading day based on the value of its holdings. The price of any sale is determined by next market close and you can expect to receive your funds within 48 hours by EFT.
Mutual funds make systematic investing easy
Most mutual funds will allow you to set up what is called an Automated Asset Builder to regularly take a set amount of money out of your bank account and invest it in the fund. This makes investing automatic and systematic, a necessity for the common sense investor. It also enables you to take advantage of a natural investing strategy called dollar cost averaging.
In summary, the benefits of mutual funds are many and they make a lot of sense as an investment vehicle for individuals who don’t have the time or money to be active investors. They provide opportunities for instant diversification, strong money management, low-minimum purchases, easy systematic investing and the virtual liquidity of an online checking account. By doing your research once to find a trustworthy and proven money manager, you can reap the rewards of rational investing without doing all of the work yourself.