Mutual or investment funds are one of the simplest and easiest ways for an investor to put their money into investment vehicles outside of keeping money in a savings account.
Although there is a higher risk due to the simple fact that mutual funds are not guaranteed like money in a bank account can be, the risk can still be managed to the point where the possible gains make the risk well worthwhile.
Why Mutual Fund Investing Is A Good Choice
Return of Investment (ROI)
Overall, by investing in financial markets, the rate of return for an investment should end up earning a better return than the interest rate that a bank would pay for keeping the money in the bank.
While it is true that an investor can reap the benefits of market investing by directly picking specific stocks to invest in there are three other advantages of mutual fund investing when compared with direct stock investing which include:
Diversity
Since the fund will invest in many different companies the exposure is spread out over all of the companies invested in and if one or some of the companies have poor results, the effect is minimized since the amount of the stock held in that one, or those few companies. is a relatively small percentage of the total fund value.
A Large Lump-Sum Amount May Not Be Required
With mutual funds smaller amounts can be invested and on a monthly basis. It is hard if not altogether impossible to buy one share of a company at at time. The price of some shares are well above the amount of money that the average investor may have. By the definition of mutual funds they allow for fractional purchases of stocks. And so, mutual funds lower if not completely eliminate the barrier of entry for the average investor to gain access to the stock market and reap the benefits of doing so.
Dollar Cost Averaging (DCA)
As mentioned above, mutual funds allow an investor to invest their money in smaller amounts and on a regular basis, say possibly as low as $50.00 monthly. By investing the same amount of money regularly DCA works for the investor since the dollar amount from each investment can end up purchasing more shares when the fund price is lower. Then when the price does goes up the amount of shares that the investment holds is higher and at the then higher price.
The advantages to mutual funds for investing are good and should be obvious to you now, but trying to figure out which mutual fund to purchase can be the challenge! There are so many different types; Where does one even start?
To get you started, we’re going to look at the different types of mutual funds, which really is the first step to finding the fund or funds that best suits your needs and preference.
At Their Most Basic Level, There Are 4 Broad Categories Of Mutual Funds:
- Equity Funds
- Fixed Income Funds
- Money Market Funds
- Balanced or Hybrid (Asset Allocation) Funds
Mutual Fund Types In More Detail:
1) Equity Funds (Stock)
These funds that invest in company stocks are by far the largest category of available funds to invest in. The objective of these funds tends to be centered on long-term growth with some income generation. There are numerous types of equity funds because there are so many types of stocks.
Some of the different classifications of equity funds and the types of companies that they typically invest in include:
- Global Funds: Investing around the world which could include your own country.
- International and Emerging Market Funds: Investing in countries outside of your own.
- Funds based on the worth of a company:
- Large-Cap: Companies with over $10 billion worth of total stock value.
- Mid-Cap: Companies between $2 billion and $10 billion worth of total stock value.
- Small-Cap: Companies with less than $2 billion worth of total stock value.
- Growth and Value Funds: Growth funds try to find the stocks that should have better than average returns while value funds look for companies with a stock price that is undervalued by the market.
- Industry or Sector Funds: Target a specific industry market, such as technology, energy, travel, health, financial and many others.
- Index Funds: Seek to mirror the actions of a specific market index, such as the NASDAQ or the NYSE. Note that index funds holdings can vary with their investment goals matching the above different types of equity funds
2) Fixed Income Funds: Bonds
These funds focus on purchasing government and corporate debts. While this sounds very simple, the are a wide variety of bond funds, with the main difference being the amount of risk associated with the bond being purchased.
Therefore a bond fund that invests in high-yield bonds, often called junk bonds, is going to have a much higher level of risk than a fund that invests primarily in government bonds. But if everything goes according to plan, the high-yield junk bond fund should provide a much higher return than a fund based on lower risk government bonds, for example.
3) Money Market Funds
These fixed income funds only invest in short-term debt, like US Treasury Bills (T-Bills) certificates of deposit (CDs)and commercial paper. Generally, they are considered one of the safest investments.
The rate of return is better than your typical savings account, but usually not by much. These funds are typically used as an alternative to a conventional savings account.
4) Balanced or Hybrid (Asset Allocation) Funds
Balanced funds invest in both a mix of stocks and debt instruments. Again, there are a wide variety of funds, depending on the types of equities and the types of debt that the funds purchases.
To add to the mix, there are also specialty or alternative funds
This bucket of fund types includes the different funds that do not specifically meet the above listed types or offer a unique way to manage the investments within the fund.
Hedge funds, managed futures, commodities and real estate investment trusts can be included here.
For the socially conscious of us that would still like to invest in markets, there are corporate socially responsible mutual funds. These funds avoid investing in controversial companies and industries like tobacco or firearms and instead target their investments towards companies with strong environmental, moral and social values and business practices.
About Rates Of Return – Things To Consider When Buying A Mutual Fund
When researching which mutual funds to get into it will be very tempting to base your decision on the historical returns of the fund. But this can be a fallacy. Reading a funds prospectus, reviewing the funds details online and with speaking to any broker worth their weight in salt will tell you that previous performance of a fund is no guarantee of the future earnings potential. In fact there are cases where a fund had a high rate of return in one year and plummeted in the following year. Yes performance should be considered, you cannot base your decision solely on the funds previous returns.
When choosing a fund to invest in you should start also consider the “What?” and the “Why?” of the fund in addition to the “How much” it made in the past.
- What type of fund is it? What does it hold its investments in and do the answers to these questions meet your investment goals and needs? Does the level if risk of the fund match your level of risk that you are willing to accept? Can you stomach the possible price fluctuations of a high return, high risk fund?
- If a fund as done well in the past Why? Was it due to a strong market, good investments or the timing and skills of the fund manager?
- If a fund has done poorly, Why? Was there a market adjustment for the industry the fund is invested in? Is that fund undervalued and poised for a rebound? Was the fund poorly managed but a new fund manager with a good track record has now taken the helm?
These are but a few of the questions and considerations that you need to ask yourself and take into account when investing in a fund, or in any other investment vehicle.
Do not rely on the sexy headline grabbing returns alone.
Mutual Fund Fees
Fees of funds can vary and can greatly affect your returns over time. Every penny of your money taken out of your investment for fees is a cost paid out up front and also can drastically your potential gains in the long run.
- You need to keep in mind that all investments have a cost associated with it.
- In the same way that compound interest works to the advantage of an investment, over time, it can be said that the money lost to fees at purchase time can negatively “compound” against the investment.
- With less money invested for each purchase a higher costing fund needs to have better returns when compared to a lower costing fund to match the returns of the lower costing fund and with all things considered to be equal, the chances of a higher fee fund outperforming a lower fee fund goes down the higher the fees are.
When comparing different mutual funds and their fees, even a small amount can make a big difference to the value in the long run.
Consider this very simple analysis using compound interest but in reverse, so to speak.
- Investment amount: $100.00 monthly
- Assumed rate of return: 10.000%
- Compounding: Monthly
- Investment Horizon: 30 Years
- Fee per purchase: 1-3% see below
Then
- If all of the $100.00 is invested, the value is $228,032.53
- For $01.00 fee, 99.00 is invested. the value is: $225,752.21
- For $02.00 fee, 98.00 is invested. the value is: $223,471.88
- For $03.00 fee, 97.00 is invested. the value is: $221,191.56
Now, if the monthly investment amount is $500.00 per month
- 1.000% is $05.00 fee
- 2.000% is $10.00 fee
- 3.000% is $15.00 fee
Then
- If all of the $500.00 is invested, the value is $1,140,162.66
- For $05.00 fee, 495.00 is invested. the value is: $1,128,761.04
- For $10.00 fee, 490.00 is invested. the value is: $1,117,359.41
- For $15.00 fee, 485.00 is invested. the value is: $1,105,957.78
Now, if the monthly investment amount is $1,000.00 per month
- 1.000% is $10.00 fee
- 2.000% is $20.00 fee
- 3.000% is $30.00 fee
Then
- If all of the $1000.00 is invested, the value is $2,280,325.32
- For $10.00 fee, 990.00 is invested. the value is: 2,257,522.07
- For $20.00 fee, 980.00 is invested. the value is: 2,234,718.82
- For $30.00 fee, 970.00 is invested. the value is: 2,211,915.56
With the above initial parameters taken into consideration, every dollar that is not invested due to the amount lost to the fees affects the end value of the investment to the tune of just over $2200.00 per dollar.
The question that an investor needs to ask themselves is, can you afford to give away $2200.00 now or at any time in your your life?
We thought not. This is why you need to consider the fees that are charged for mutual funds.
Typically, Mutual Fund Fees Are Of Two Main Classes
1) The annual fund operating expenses: Fees covering the cost of paying fund managers, legal and administrative fees such as the lawyers and accountants, marketing and so on.
The prospectus should list the fee for the fund’s “Total Annual Operating Expenses.” Listed ongoing costs may include:
- Management fees: The cost to pay fund managers and investment advisors.
- 12b-1 fees: Typically capped at 1%, these fees pay for the cost of marketing and selling the fund and other shareholder services.
- Other expenses: Can include legal, accounting, and other administrative costs.
The total annual fund operating expenses are expressed as a percentage of the fund’s net average assets.
2) Shareholder fees: These include sales commissions and any other one-time charges from buying or selling the mutual fund shares.
- Sales loads: Commissions paid when fund shares are bought or sold.
- Redemption fee: Possible fee if shares are sold within a specified time period the purchase. The time period may be calculated by days or can even be over a year.
- Exchange fee: Fee charged if shares are exchanged (or transfered) to another fund offered by the same investment company.
- Account fee: A fee charged to maintain an account, typically if the balance falls below a specified minimum investment amount.
- Purchase fee: A fee paid to the fund at the time of purchase (different from the front-end sales load, which is paid to the broker for selling the fund).
There are funds that advertise themselves as “no-load” funds but as we have stated above, all investments have a cost and even if the mutual fund doesn’t charge a sales load, it may charge other fees for redemption, transfer or exchange, purchase and account fees.
The above list is may not be exhaustive or complete and applies mostly to mutual funds sold in The United States. Before investing, know what all of the fees are and how they affect the amount of money that is invested and the growth of the investment itself.
Any investor should have the right to know what any and all of the fees are before making their purchase. No information should be hidden from an investor. But do not count on being told information if you do not ask for it, so be sure that you ask before you invest.
Conclusion
Now that you know the basics, it will make the challenge of choosing a mutual fund a little bit easier.
Keep increasing your investment IQ; After all, it is your money and your responsibility to have it make the most for you.
BAM! Be A Man. Do The Right Thing. Take Care Of Yourself And Your Money
BAM! Be A Man. Do The Right Thing.
Be The DtRTy Guy!
