By Adam Baley
With nearly $16 trillion in assets and more than 8,000 funds to choose from, mutual funds form the largest component of the investing world.
A mutual fund pools money from various people and invests it on their behalf. Guided by specific investment objectives, fund managers invest the pool of money in individual securities, such as stocks and bonds. When you own shares of a mutual fund, you participate in the gains and losses of that fund’s investments.
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The idea of pooling investment resources can be traced back to 19th century Europe.
But it wasn’t until 1980s America that the popularity of mutual funds really took off with the rise of employer-sponsored 401(k) retirement savings plans to replace defined-benefit pension funds.
The pooling nature of mutual funds offers a greater ability to control risk through diversification, allowing shareholders to easily put their investment eggs into multiple baskets.
Each fund has an investment objective or strategy. One might be for long-term growth and invest in dividend-paying stocks. Another fund might focus on preserving principal and invest in high-quality bonds. Different types of funds play various roles in your portfolio allocation and together can lead to diversification and balance.
Despite their variations, mutual funds share some common benefits. Here are four key advantages.
Professional management
Few individuals have the time, resources and expertise needed to properly manage investments. Mutual funds employ a full-time staff of managers and research analysts.
Fund management teams handle day-to-day oversight of a fund’s investments as well as the buying and selling of securities for the fund.
Mutual Fund 101
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Some mutual fund managers are more active than others. Index funds take a passive approach, buying all securities in a given index and making no attempt to sift out good companies from bad. On the other hand, active managers work with research analysts to invest in areas they consider most profitable and least risky for their fund’s objectives. (Click here to learn more about active vs. passive management.)
Diversification
Mutual funds invest in dozens, if not hundreds, of individual stocks and bonds from different sectors, markets and countries. It would be difficult for any individual to match the diversification you find in a mutual fund.
While owning a diverse mix doesn’t eliminate risk, it does reduce the volatility associated with any individual security over time. A variety of investments can offset one another, helping to smooth out the ride.
Affordability
On your own, it would cost a lot of time and money to build and maintain a portfolio consisting of hundreds of stocks and bonds. By pooling their investments, mutual fund shareholders create economies of scale.
A mutual fund buys and sells large amounts of securities at a time, so its transaction costs are lower than what an individual would pay. As mutual funds grow, fund families typically pass savings to their investors through lower fees.
Liquidity
Just like an individual stock, a mutual fund allows you to convert your shares to cash at any time. However, unlike stocks, which can rapidly change value throughout the trading day, mutual funds are priced once per day.
Exchange-traded funds (ETFs), like stocks, change value second-to-second. During the autumn of 2015, a few days of heightened volatility resulted in some ETFs being unable to determine their price until hours after the markets had closed. Mutual funds did not have that problem. (Click here to learn more about ETFs.)
Behind every successful investment strategy lies a balance of risk and return. Mutual funds are a key tool in finding that balance. They offer a relatively affordable way to build a diversified portfolio, with access to liquidity and professional management.
Adam Baley is a registered representative and investment advisor at Landaas & Company.
Learn more:
Mutual Funds, from the Financial Industry Regulatory Authority
Mutual Funds: A Guide for Investors, from the Securities and Exchange Commission
(initially posted Feb. 8, 2016)
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