For a better understanding of mutual funds, you have to see how they fit into the overall world of investing.
Firstly, they wholly rely on investments like stocks, bonds, CDs and others with which you may be familiar. Secondly, as opposed to investing on your own, when you invest in a mutual fund you contribute to a pile of money that the fund manager will use to spend on large, worthy investments.
Since no two mutual fund managers invest exactly the same way, you need to understand where each may invest your money to avoid locking yourself into a decision you do not agree with and have your money work hardest for you.
That being said, you should invest in mutual funds if you want to diversify your investments and spread the risk over multiple holdings. Utilize different funds for different financial goals such as a home, a car or an emergency savings account — especially if the measly savings account interest rate just won’t cut it.
A mutual fund will also save you time in researching and investing and should earn more than if you performed the very same investments on your own. Some funds are tax free, but most funds will take that money away from you in operating costs. If you are too overwhelmed and not ready to get involved, seek out a personal financial advisor.
Let’s begin with the three basic different types of funds you could invest with: money market funds, bond funds and stock funds.
Money Market Funds
Not to be confused with money market accounts, these mutual funds have the unique characteristic of being the only type where share price will not fluctuate in value since it is locked at $1 per share. Your invested principle will not likely decrease in value because money funds invest in only the “safest” securities such as:
- Commercial paper
- Certificates of deposit
- Government debt
The money fund yields are better than your average checking account, and you will still be allowed to write a few large checks (usually $250 minimum) against the account. Ideally, your money fund should replace your savings account or you should begin siphoning off from the latter to support the former. Furthermore, savings accounts are taxed while mutual funds are often tax-free.
Most MMFs require a minimum investment of around $3,000 to $5,000, much more than your average savings account. Nevertheless, because they have such low risk relative to other mutual funds your operating expenses should not exceed 0.5 percent.
Bond funds are essentially mutual funds of various sizes, stuffed with corporate or government sold bonds you can purchase to gain interest. The time frame is usually under five years, five to ten years, or 15 to 20 years.
Either way, these mutual funds live for significantly longer than a MMF, come with a greater risk and subsequently a greater reward. Bond funds should never be a placeholder for emergency money because of the volatile nature of the bond market.
If you have money you know you will not use for at least the next few years, throw it in a bond fund and don’t look at it until time runs out because its value bounces all over the market as it reaches maturity. Only at this point in time can you be sure to come out with more than your original investment.
Here are five common bond mutual funds:
- Investment Grade Corporate Bond Funds
- High-Yield Bond Mutual Funds
- Treasury-Inflation Protected Securities (TIPS) Bond Mutual Funds
- Municipal Bond Mutual Funds
- International Bond Mutual Funds
These mutual funds, also known as equity funds, comprise the longest-term mutual funds and require a more investigative approach.
Stocks can plummet overnight, so buying a single stock has inherent risks. The beauty of using a mutual fund to invest in stocks is that you can own share of many stocks to reduce risk. If your stock mutual fund holds 100 stocks and one dies, you only lose two percent of the fund’s value. However, your fund manager is more likely to see these risks than you.
Stock funds epitomize the advantages of diversification because of the huge amount of stock choices and investment strategies that a manager can employ. Not only does a stock fund represent many various companies, investing in multiple funds puts potentially thousands of stocks in your possession, almost eliminating risk.
The nature of the stock market encourages a constant infusion of money to increase reward, but this also increases your exposure to risk.
Finding the Best Mutual Fund
So how do you invest in a mutual fund while also making sure your money does not disappear overnight? With Mutual Funds its easy for your eyes to start to glaze over with thousands of options and types to choose from, knowing what you want and what to look for can help narrow down your choices. (Don’t forget ETF-variants of mutual funds.)
From the start you need to be involved for quite some time. Depending on your investment techniques the value of your fund can vacillate, but this isn’t the stock market; mutual funds hope to report earnings over years, not minutes.
Consider the difference between an index fund and an active fund. Low-cost index funds like an S&P 500 Index will mirror the choices the S&P made of those 500 stocks and will generally outperform actively managed peers investing in similar securities. However, these indices are often run by computers and their lack of risk translates into relatively small rewards.
But, it also goes beyond just choosing award-winning funds, you need to consider the manager and firm handling these funds. A clear measure, if you can get it, is how much of the manager’s personal wealth is invested in the fund you are interested in. You see, fund managers get paid based on the level of assets they manage. Therefore when their clients do well, they do well. If you can find a fund manager who is also invested in funds your participating in, motivation for these to do well is obviously higher.
At MyBankTracker.com, we like to have a clear understanding on funds that have won awards, but never should this be the determining factor, instead your goals should always be the main determining factor.
Looking beyond, the manager or your goals, you may want to also consider the company you choose to manage you money. In this case, awards mean less than they do for specific funds. Some companies are known for low fees and other offer comprehensive options such as financial advisors and target-date retirement funds. Like any business companies have their strengths and weaknesses and so you need to align with a company whose strengths match your goals.
The SEC defines a mutual fund as a type of investment company that pools money from many investors and invests the money in stocks, bonds, money-market instruments, other securities, or even cash.
While a single mutual fund usually invests in about 25 to 100 of these holdings, you may still want to diversify your investments to include multiple types of funds. If a mutual fund spreads your money across investments, then spreading across mutual funds diversifies your holdings even more.
Therefore, consider mutual funds for the long haul when you have excess cash to put away. They are best utilized over ten years or more because it allows a long enough horizon to invest in stocks as well as bonds.
The long-term investment combined with high risk mark mutual funds as some of the best investments you can make. The risk, namely the possibility of losing a portion or even the entire original amount invested, is also the reason why diversifying your investments is so fundamental to success.