Mutual funds are a financial vehicle in which over half of U.S. households invest their hard earned money into, but how much do you truly know about them? When fully understood and invested in, mutual funds can be a very profitable and relatively simple way for the average person to increase their savings.
Simply put, mutual funds are a collection of stocks, bonds, and other securities. They are created when a company brings together a group of people and invests their money in a group of securities. When it comes to making money with mutual funds, there are three different ways in which to do so.
One of the ways an investor can make money with a mutual fund is in the distribution of income earned by the fund on dividends from stocks and interest on bonds. A fund tends to pay out nearly all of the income it earns in a year to its owners. The second way to make money with a mutual fund occurs when the fund sells securities it owns that have increased in price. The gains made on these sales are also usually passed on to fund owners. The final way a mutual fund can make an investor money comes when fund holdings increase, but not sold by the fund manager. In this instance, the fund’s share price increases, and an investor can then sell their fund shares at higher price than they paid, hence making a profit.
While mutual funds seem relatively simple and straight forward in the ways they make money, they do in fact have several advantages and disadvantages to their usage.
There are several advantages for the usage of mutual funds by investors. The primary advantage of investing in mutual funds is the professional management of one’s investment. Many investors purchase mutual funds because they do not have the time, resources, or knowledge to properly invest their money themselves, and a mutual fund presents an inexpensive option for a small investor to get a full-time money manager to make and monitor investments.
Another advantage of a mutual fund is the diversification it presents. When investing in a mutual fund, risk is spread out because of the hundreds of different stocks from a variety of industries that funds tend to own. For a small-time investor with a relatively small amount of money, having a highly diversified portfolio like that of a mutual fund is just not possible.
In addition to diversification, the concept of economies of scale that can be seen in mutual funds presents another advantage to investing in them. Because these funds buy and sell such large amounts of securities at a time, its transaction costs are lower than what an individual investor would have to pay making securities transactions.
Other advantages of mutual funds include their liquidity, as they can be converted into cash easily, and simplicity, as they are relatively easy to understand and invest in. Many have small minimum investment amounts and the average investor can easily gain ownership of shares.
Though there are many advantages to mutual funds, they have a few disadvantages as well. Though listed as an advantage above, the professional management of one’s money in a mutual fund can be viewed as a disadvantage. This is because fund managers can be irresponsible, and sometimes just plain wrong in their stock picking, as well as the fact that the average investor can sometimes perform just as well, if not better, than professional money managers. One thing to keep in mind with mutual funds and their managers is that even if the fund loses money, the manager still gets paid.
Another disadvantage with mutual funds are the costs associated with them. The costs of creating, distributing, and running a mutual fund can really add up, and they are all passed on to the investors. Fees can vary between different funds though, so potential investors just have to be conscious of them before buying shares. Similar to costs, investors should also be aware of the taxes associated with mutual funds. When a fund manager sells a security, there is a capital gains tax that is applied. The taxes associated with mutual funds can sometimes be mitigated or avoided in some cases. Investors can invest in tax-sensitive funds, or hold non tax-sensitive funds in a tax deferred account, like their IRA or 401K account.
As mentioned earlier, an advantage of mutual funds is diversification, or the spreading out of risk. But there is a certain point where too much diversification can be a bad thing. This is what’s called dilution, where there is too much diversification and the potential gain of a few stocks can have relatively little effect on the overall portfolio’s performance, since they are given a smaller weight.
Overall, mutual funds can present an incredibly intriguing investment opportunity for those with lower amounts of capital that are looking to place their money in the stock market. Mutual funds are relatively simple, easy to use, and diversified investment vehicles that allow smaller investors to invest in a wide variety of stocks in many different industries, as well as give investors the chance to have professional money managers handle their capital. While mutual funds also have their disadvantages, potential investors everywhere should keep them in mind when considering where to invest their hard-earned money.
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