Mutual Funds: Investing for the Masses
An Introduction to Investment Planning – Part 5.1
What is a mutual fund?
At its simplest a mutual fund is a pool of money that has been invested in a collection of stocks – in the case of an equity fund – that have been chosen by the mutual fund manager. The mutual fund company then sells units of that fund to investors. When you buy a mutual fund, you along with many thousands of other people, “mutually” own units in that fund.
What are its benefits?
Mutual funds give investors with relatively small amounts of money the opportunity to invest in a professionally managed portfolio of stocks, bonds or other investment securities. How small? If you go to your local bank, you may be able to make your initial purchase with as little as one hundred dollars and set up a systematic investment plan with as little as an extra $25 per month.
Why can’t I just buy individual stocks?
Investors certainly can choose to buy individual stocks, but there are two challenges that immediately come to mind when taking that approach. First, unless you have enough in the way of investable assets to hire an investment advisor or portfolio manager, you will be making your own decisions concerning which stocks to buy. A mutual fund manager will be a highly trained analyst who will in turn be leading a team of analysts, all of whom are capable of assessing the past performance and anticipating future prospects of the investments they put into a mutual fund. Not too many of us have that ability or training.
Second, even if you are well-trained, you may not have sufficient cash on hand to buy the optimum mix of stocks, bonds and or other investments to make up a properly diversified portfolio.
What are the drawbacks of mutual funds?
Lack of customization
There are thousands of mutual funds available for sale in Canada so this shouldn’t be too much of a problem. Even so, without buying individual securities, you cannot precisely control the assets you own.
Fees
Mutual funds do not just arise out of thin air. The mutual fund company needs to hire a full range of staff to create and manage the fund. For actively managed mutual funds, research is an expensive proposition. In addition, there are marketing expenses that need to be taken into account. It is not uncommon to pay two percent or greater per year for a mutual fund. This fee is known as the Management Expense Ratio or MER.
Risk of loss
Unlike with individual stocks or bonds, when you buy a mutual fund, you own a portion of a diversified portfolio of investments. That diversification reduces the risk of loss but does not eliminate it altogether. Unlike an individual stock or bond, it is unlikely that a mutual fund will go to zero, but it is still possible that you will lose money even while owning a well managed mutual fund. Past performance is no guarantee of how the mutual fund will perform in the future.
More to come on mutual funds in the next post, when I will look at “loads.”
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.