Are you wondering what to do with your surplus income? If you are one of the Americans fortunate enough to avoid living from paycheck to paycheck, investing your extra money helps you enjoy a comfortable retirement.
However, what investments make the most sense for your financial position? There are hundreds of ways to make your money grow. Each of them come with differing levels of risk and reward. Mutual funds are some of the most popular low-risk investment vehicles available.
What is a mutual fund? How does it differ from other investment available to you?
This article explains everything you need to know about mutual funds, allowing you to make an educated investment decision on the viability of this financial vehicle.
Mutual Funds Explained
There are over 7,000-mutual funds available from financial institutions and firms. Each of the funds has different managers that have a specific investment style. The objectives and goals of the fund depend primarily on the management and asset classes that constitute the fund.
When you invest your money in a mutual fund, the institution pools your money in a segregated account, along with all the other funds from other investors. This strategy allows the fund manager to leverage the buying power of the fund, spreading the money across multiple different asset classes.
Fund managers invest in a range of assets, such as index and property funds, bonds, stocks, and ETFs. This diversification strategy allows them to minimize risk in losing money to the markets while maximizing the returns on their investments.
Mutual Fund Investment Strategies
The investment strategy of the fund can range from conservative to moderate or aggressive. A conservative fund provides slower growth in your money than an aggressive fund, but it reduces risk to a market shock. Since all mutual funds have exposure to the worlds currency, stock, and bond markets, they run the risk of losing money in the case of a market crash.
- If the fund manager has an aggressive strategy, then they typically invest in riskier assets, such as stocks, that have a higher exposure to a market shock. Should the manager be using a conservative strategy, they invest in assets like property funds and government bonds, that are far more stable if a financial crisis shows up.
- When you decide to invest in a mutual fund, you must review the fund manager’s strategy, and understand what they are doing with your money. If you have a low-risk tolerance, then you can’t stand the thought of losing money. Seeing half of your funds capital wiped out overnight in a market crash will leave your head spinning.
- If you do have a higher risk tolerance, and you aren’t concerned about a market crash, then a high-risk mutual fund is your best option. While these strategies involve higher risk, they also offer much higher returns.
- Choosing the fund that matches your risk tolerance is a vital step in managing your investments, and it’s different for everyone. Seniors and people who are closer to retirement may want to choose a fund that offers steady returns and lower risk. These individuals can’t afford to lose money, as it may affect their standard of living during their retirement years.
However, young people who are starting their careers have more room for error. Their financial position will not be adversely affected if the market takes a knock, and there is plenty of time for them to recover any losses.
Fees Involved with Mutual Funds
Each fund has different charges based on their risk exposure and past performance. Fees can eat into your annual returns, so always ensure that you take a look at the investment prospectus before committing to the fund.
All funds are required to be transparent with costs in the prospectus, and most of them post them on their website for investors to view. The expense ratio on the fund’s prospectus gives you the best insight into costs involved with your investment. Typically, you’ll want to find a fund that offers less than 1-percent on fees.
It’s important to note that fees are a significant factor when calculating your returns, and the previous year is not an accurate indicator of future performance. The fund’s expenses can also adversely affect the profits of your investment, and the fund always reports returns net of costs. Other expenses involved include marketing costs and trading fees for managing your money.
Finding the Best Performing Funds
There are companies online that analyze fund performance. These companies report research and statistics on the fund’s returns and management. If you’re looking to invest in an MF, then Morningstar is an excellent research firm. They provide you with the information you need to make an informed investment decision on where to park your money.
How to Invest in a Mutual Fund
When you’re ready to invest in a Mutual fund, you can find them online from investment firms like Charles Schwab and Vanguard. These platforms allow you to tailor your risk exposure, giving you the option of where you want the fund to manage to invest your money. You have the option of investing in international and local stocks and bonds, as well as a diverse range of indexes, ETFs and other paper assets.
When it comes time to invest your money, it’s a prudent strategy to speak to an advisor about your choice of MF. Financial advisors often deal with one financial firm that they think offers the best returns for their clients. You might make the mistake of thinking that the advisor is only in the deal to make money off recommending you a specific fund.
While this is partially true, the advisor stakes their reputation on the mutual fund’s performance. If they consistently recommend inadequately performing funds, then their clients will abandon them for another advisor. Therefore, they have an incentive to only work with the best performing MF products.
An advisor can also assist you with other investment ideas, and give insight on your investments to meet your financial situation and goals.
Mutual Funds Vs. Stock Investing
So, why should you invest in a mutual fund, instead of in the stock market? The S&P500 is currently experiencing the lengthiest and most extended bull market in its history, with the index topping out over the 3,000-mark in recent months. The average returns in the S&P500 have far eclipsed anything a mutual fund can offer in performance over the same period.
The S&P500 consists of the 500-best performing companies on the Dow Jones Index, and they are the darlings of the investment world. Look through the stocks in this index, and you’ll find heavy hitters like Facebook, Google, Amazon, and Netflix. All of these stocks cost upwards of $100 to $200 for a single share, and they are the most valuable companies in the world.
However, the S&P500 also experiences periods of volatility where the prices on these stocks could soar or crash. A bad earnings report, or an announcement that the company’s management is leaving, may cause substantial moves in the price action of the stock.
As a private investor, it’s easy to open a brokerage account and trade these stocks using your money. In most cases, you don’t need a financial advisor for this if you understand how to place a trade by yourself. However, to trade stocks, you need at least $25,000 in your account if you want to trade more than 5-times a month.
Considering the high price of these stocks, you’ll also only be able to buy a few shares of a company if you have a small trading account. Five shares of Tesla could cost you nearly a thousand dollars, and then all of your money has full exposure to this single stock. If the company goes down, you lose your money.
By investing in a mutual fund, your investment manager gets to leverage all of the pooled funds in the account. This strategy allows the fund manager to buy a diverse range of stocks on various indices, reducing your exposure to a single company. This diversification strategy will enable you to be involved in numerous assets at once, reducing your risk of losing money if one of the company’s tanks.
Mutual Funds Vs. Bond Investing
Government bonds and treasury notes are a favorite for investors. Betting your money on the fiscal health of the country and its dominance as the world’s superpower has significant perks. Parking funds in government bonds requires you to deal with a broker that can facilitate the transaction on your behalf. Similar to stocks, you can trade these assets without the use of a broker, but you put yourself at higher risk of making a mistake.
Unfortunately, government bonds and treasury notes do not have a high yield. The return on these assets depends on the current interest rate environment, set by the Federal Reserve. The Fed is about to end its current run of tightening policy, where it will start to drop rates. As a result, anyone holding bonds or treasury notes will begin to see a reduction in the performance of these assets.
Mutual funds allow you to invest in bonds and treasury notes, from governments all over the globe. Some countries in emerging markets have far higher yields on their government debt that the United States, allowing investors to maximize returns when compared to local assets.
However, investors that take a chance on emerging markets are also at risk of higher volatility in the market as well. Investing in EU or US government debt is more stable than that offered by emerging markets.
When you park your money in a mutual fund, the fund manager takes positions in bonds and treasury notes from all around the world. This strategy helps you to mitigate risk while improving liquidity in your investment.
Mutual Funds Vs. Real Estate
Real estate is a favorite investment vehicle of thousands of investor all around the world. Real estate provides a tangible asset that offers moderate to slow returns on your money. Taking your surplus funds and pouring them into your mortgage is a great way to invest in your retirement.
However, with this strategy, you are only growing equity in your home. For instance, if you bought your home for $200,000 five years ago, and have since paid $50,000 into the bond, then you have $50,000 worth on equity in your home.
Lenders will let you borrow against this equity, and extend your mortgage to meet the new debt you owe the lender. Many investors take this equity and invest it into a down payment on another investment property that produces monthly rental income.
However, there are hassles involved with this investment strategy. Some tenants may damage your property or stop paying rent, leaving you with two mortgages to take care of at the end of the month. If you fail to pay the mortgage due to your tenants defaulting, then the bank may foreclose on your home to recover the funds.
Mutual fund managers invest in property funds that provide a stable return. At the same time, you don’t have to worry about tenants or maintenance on the property. Mutual funds are far more liquid than buying a property. While some funds may penalize you for taking out your money before a specified date, they still give you the cash on your request.
If you purchased a second property, and have to sell it quickly, you may struggle to find a buyer. As a result, you may end up selling the home below its asking price, losing money on the deal.
Wrapping Up – Understand Your Risk Exposure
By now, you should have a clear understanding of a mutual fund, and how you can use it to grow your money. However, the key takeaway for this article should be in understanding your risk tolerance.
When opening a mutual fund, you must take advice in managing your risk exposure. While mutual funds are reasonably safe assets, they still come with a certain level of risk. Speak to a financial advisor before you commit to any fund.