Mutual Fund Investing: If you don't want to invest in individual stocks, another popular investment choice is mutual funds. Investing in individual stocks has higher risk as compared to mutual funds. Mutual funds are an investment through which you can invest in stocks and bonds indirectly. Since mutual funds usually work with a basket of stocks rather than a big position in just one stock, there risk is much lower than individual securities. For example, a mutual fund specialized in energy sector will invest in 10 to 15 stocks in the energy sector with a limit on the size of each position. This allows a mutual fund to spread the risk over a wider spectrum and also take full advantage of the growth potential of each stock.
What exactly is a Mutual Fund?
A mutual fund is a portfolio of stocks, bonds, or other securities that is collectively owned by hundreds or thousands of investors and managed by a professional investment company. The shareholders are people who have similar investment goals. Each fund has specific investment criteria, which are spelled out in its prospectus, the official booklet that describes the mutual fund. Investors then know what they are getting and can match their objective to that of a fund. The pooled money has more buying power than one investor alone, so that a fund can own hundreds of different securities. Thus, its success is not dependent on how just one or two companies perform.
A mutual fund makes money in several ways: by earning dividends or interest on the investments it owns and by selling securities that have appreciated in value. You, in turn, make money in the form of dividends and interest that are passed on to you and the increase (or decrease) in the fund's value. The mutual fund manager keeps constant watch on financial markets and adjusts the portfolio to achieve the strongest returns. By owning part of a fund, the hard work of selecting and monitoring stocks and bonds is done for you.
The majority of mutual funds available are open-end funds, which are the focus of this unit. Open-end funds can have an unlimited number of investors or money in the fund. Managers of closed-end funds, on the other hand, decide up front how many shares they will issue and when they will sell them. The only way to purchase shares in a closed-end fund, once the original shares have been sold, is to buy them from a current investor. Occasionally, open-end funds can and do close to new investors, often because of high cash inflows that cannot be invested in a timely manner. They do not become closed-end funds, however, because current shareholders can still buy additional shares from the fund company.
When investors purchase a mutual fund, they own a piece of an investment portfolio. They share in the gains, losses, and expenses in proportion to the amount they have invested in the fund. At the close of every trading day, a mutual fund company tallies the value of all the securities in its portfolio and deducts its expenses (e.g., management fees, administrative expenses, advertising costs). The balance is divided by the number of shares owned by shareholders to arrive at the dollar value of one share of the mutual fund. This value, the net asset value or NAV, is the price your fund pays you per share when you sell.
 Reasons to invest in Mutual Funds :
 One of the most important advantages of mutual fund is diversification. Your investment risk is greatly reduced through diversification because a mutual fun owns many stocks and/or bonds. Also, you have an option to select mutual funds by different level of risk. For example, if growth is your primary focus, you can select mutual funds with aggressive investment strategy. On the other hand, if you're looking to established a fixed income stream and more stability in your portfolio, you can select mutual funds investing in high grade bonds and money market funds. Whatever is your investment goal, you can find a mutual fund to match your goal and strategy.
Mutual funds also offer you a great advantage because they are professionally managed. Now what does that mean? Professional management means that fund is managed by group of people with lot more financial experience than an average investor. These fund managers also spend lot more time analyzing the market to figure out the best investment strategy and choices. Since most people do not have the time or skill to select and monitor individual stocks and bonds, a professionally managed mutual fund offers piece of mind and better future.
You will earn competitive returns on your investment. Mutual funds can offer decent returns you need to reach your goals. Also, if you're more interested in a certain index performance, for example, an index fund, (a fund that invests in securities of one of the broadly based market indexes such as Standard and Poor’s 500), you can expect to match the market’s performance, minus the expenses of running the fund. This is an assurance that no other investment can provide. This is a great investment option for people who are looking to develop a long term investment strategy but don't really know where to start.
You don’t need a fortune to get started. Many funds require only $1,000 to open an account, and some funds require minimum initial investments as low as $250 to $500. Subsequent deposits can be as small as $25 to $100 if an automatic investment plan (AIP) is adopted. An AIP is an arrangement where you agree to have money automatically withdrawn from your bank account on a regular basis, (e.g., once a month or every quarter) and used to purchase fund shares. If you are looking to get an Roth or traditional IRA account but don't have $4,000 or the full year max allowed, you can pick a mutual fund and put as little as $100 a month.
You retain ready access to your money. A mutual fund is required to buy back your shares, which makes withdrawals easy. It will mail your check within seven days of the request at the closing price (NAV) on the day it is received. (An exception to receiving NAV at sale time is back-end load funds that charge a redemption fee). You also have a better visibility about your account since you can check the NAV price online or by calling a toll free number. Also, redemption fees are disclosed to customer at the time of,e the invest in a mutual fun, so you always know how much it would cost you to liquidate your holdings.
Mutual funds are a cheaper way to get the investing job done. Research and operating costs are shared by the thousands of shareholders. The most efficiently run funds have an expense ratio (the percentage of fund assets deducted for management and operating expenses) of less than 1% a year. Some well-established funds charge annual fees as low as 0.2% to 0.5%. Also, many funds are sold directly through their sponsors with no sales charge-known as "no-load" funds. Funds that charge a sales commission are called "load" funds. Earnings from mutual funds can also be automatically reinvested in additional shares. Reinvesting and compounding are keys to building wealth.
Automatic withdrawal plans are available, making it possible to have a steady stream of income for retirement (e.g., withdrawals of $500 per month).
Mutual funds have less risk of bankruptcy or fraud than many other securities because they are highly regulated by the federal government through the SEC, which is charged with assuring that mutual funds and investment advisors follow specific rules of disclosure. They also have better transparency because there are rating agencies that rate mutual funds based on their performance. Morningstar rates funds using a "star" system--with five stars being the highest rating and one star being the lowest rating.
Monitoring mutual funds is simple. Prices are reported daily in the financial section of many newspapers and more in-depth information is available in the Sunday business sections. Your account balance is also updated on a daily basis and you can monitor the performance of your investment without keeping the price history of the mutual fund you're invested in.
Reasons not to invest in Mutual Funds :
Mutual funds can drop in value if market corrects itself. Also, if you're investing in a load fund, you're paying as high as 6% up front to acquire the shares that can even drop in value later. For example, let's say you're investing in american funds mutual funds. Most mutual funds offered by them have a load of 4-6%, so a $4,000 investment will result $3,760 in your account balance. Now this fund must return at least 6.4% in next year just to get back to your original investment of $4,000. If you're in bear market, you could easily lose another 5%-10% of your initial investment, making it more difficult to make money on your investment.
There is no guaranteed rate of return with mutual funds as there is with CDs and Treasury securities. Since risk is higher, the likelihood of greater earnings is increased. You must also pay close attention to redemption fees. Some funds have as high as 2% in redemption fees and expense ratios. If your account balance in significant, fund expense ratio and redemption fees can take a heavy toll. Some mutual funds put too much emphasis on short term returns, while mask their long term returns. If you're not careful, you might get sucked in a mutual fund with high volatility and low returns.
Unwanted taxable distributions can also be a disadvantage. Funds are required to pay out 98% of their dividends, interest, and capital gains annually. Taxes must be paid on these distributions, even if you never received them but instead reinvested them in additional shares. Unfortunately, sometimes you can also owe taxes even if your fund lost money for the year. However, this is a non-issue, if funds are held in a tax-deferred account such as a 401(k) or IRA.
Record-keeping for tax purposes can be hard work. Investors who are not meticulous about keeping track of fund purchases and sales may end up paying higher taxes than are actually owed at the time of sale because of a miscalculation of their cost basis. This is the amount of your original deposit, plus additional contributions and reinvested dividends and capital gains. The amount of taxes you pay will vary depending on the method you use to calculate your gain or loss (e.g., average price, first-in, first-out, or specific identification). Thus, it is important to keep every annual statement for as long as you own the fund. |
