Laura explains what a mutual fund is, the primary types of funds, their benefits, and how to purchase them.
Laura explains what a mutual fund is, the primary types of funds, their benefits, and how to purchase them.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Investors have many options, including stocks, bonds, real estate, and alternatives like commodities, currencies, art, and other collectibles. If you're an expert in a particular industry or want to do extensive research on a type of investment, you might enjoy buying and selling individual securities, like stocks.
But if you want a hassle-free way to get a good return on your money, there's an easier way, called mutual funds. They do the hard work for you and offer loads of advantages. This post will review what a mutual fund is, the primary types of funds, their benefits, and how to purchase them.
Welcome back, everyone, and thanks for joining me on episode 868 of the Money Girl podcast! I'm Laura Adams, an award-winning author, female money speaker, founder of The Money Stack newsletter, and host of this show with over 43 million downloads.
If you're getting value from the free content we love creating, consider submitting a 5-star rating or review on Apple Podcasts, Spotify, or wherever you're listening! If you have a question you'd like me to cover, please leave it on our voicemail line at 302-364-0308. You can also send an email and sign up for the free Money Stack newsletter at LauraDAdams.com.
What is a mutual fund?
A mutual fund is a basket of investments, known as a portfolio, that investors can buy. Mutual funds are run by professional managers who pool funds from many investors to purchase securities like stocks and bonds.
Most mutual funds have many thousands of investors and hold hundreds of millions or even billions of dollars to invest. Each share of a mutual fund represents ownership in the fund and the income it generates. Buying shares in one or more mutual funds is an easy way to purchase stocks, bonds, or other assets.
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Benefits of investing in mutual funds
Mutual funds are extremely popular because they give investors the following four benefits.
1. Having professional management.
As I mentioned, many mutual funds are actively run by managers who research what the fund will buy and sell, and closely monitor its performance. The managers buy securities in large quantities and must abide by the fund's stated objectives and investing rules.
Therefore, when you buy a mutual fund, you also buy the knowledge and experience of the people who manage it. Researching and picking individual investments is a task that most people don't have the time, interest, or skill to do.
2. Getting diversification.
Since most mutual funds invest in dozens or even hundreds of securities, they give you instant diversification, which is a significant benefit. If you pick individual stocks on your own and one plummets, you could lose a substantial amount of money.
However, diversifying or spreading your money across many securities in a mutual fund reduces risk without sacrificing potential return. One poor-performing security gets smoothed out by others that maintain their values or go up.
Mutual funds can give you exposure to many asset classes, like large and small companies, those paying dividends, various industries, and companies in developed or emerging market countries. You can be diversified among corporate, government, and international securities for bonds.
Owning various assets and classes means they would not likely move in lockstep to economic changes. For instance, if you only invest in technology stocks, you have a high risk that bad news in the sector would cause your portfolio to dive.
3. Keeping costs low.
While buying and selling hundreds of assets, like stocks, as an individual investor, would be expensive due to sales commissions, mutual funds aren't without fees. They must be compensated for their expertise and convenience, after all.
Remember that the more you pay in investment fees, the lower your returns. So, carefully compare funds' expense ratios, which are expressed as a percentage. That's what the fund charges to cover its operating expenses, like administration and marketing.
Also, look for "loads," which are one-time sales commissions you pay when you buy certain mutual funds. However, there are also no-load funds that don't have a commission.
4. Automatic reinvestment of earnings.
Dividends paid by stocks, interest from bonds, and capital gains earned by selling securities in a mutual fund's portfolio can be automatically reinvested for you in the form of additional shares.
READ ALSO: How should a novice investor get started?
What are the different types of funds?
There are four main types of investment funds you should be familiar with.
1. Actively managed funds.
These employ professional managers who choose from among thousands of securities and buy and sell them to deliver the best possible results for investors. As I mentioned, they research companies and try to determine which ones will be successful based on their industry, products, sales, profits, and competition.
2. Index funds.
These funds track indexes or broad baskets of different securities. They're not actively managed by experts trying to beat the market and typically have lower costs. Instead, an index fund aims to match a market, such as the Standard & Poor's 500-stock index.
Many index funds are designed to mimic the S&P 500, which measures the performance of 500 large U.S. companies. Over long periods, it's returned nearly 11% per year, on average.
There are index funds that mimic other benchmarks, like stocks of small U.S. companies, different types of foreign stocks, the foreign and domestic bond markets, and industries such as energy and health care.
3. Exchange-traded funds.
Exchange-traded funds, or ETFs, aren't technically mutual funds. They're a mashup of an index fund and a stock. Like index funds, ETFs hold baskets of securities that follow indexes.
Unlike mutual funds, which get priced just once at the end of each trading day, ETFs trade like stocks throughout the day. Because you can buy as little as a single share of an ETF, the minimum investment for owning an ETF is typically far less than a mutual fund.
Ongoing ETF fees are low, and some investment companies and brokerages offer a selection of commission-free ETFs. Given that most actively managed funds do not beat the market over the long term, the popularity of index funds and ETFs has skyrocketed.
4. Target-date funds.
These funds have a name that includes the year closest to when you expect to retire. For example, if you're 40 in 2024 and plan to retire around 2050, you'd choose a fund with 2050 in its name.
Target-date funds own various securities that change in allocation over time. As the fund approaches the target date, it becomes more conservative, lowering the percentage of stocks in favor of more bonds and cash. That reduces the fund's volatility as the target date approaches, helping to reduce the likelihood of significant losses as you near the year you plan to retire.
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How to choose funds?
When you need to choose funds from a brokerage account or retirement account's investment menu, many people look at their past performance. Remember that a great one-year record says little about likely future results.
Good long-term results, such as at least ten years, can indicate if an actively managed mutual fund is well managed. With passively managed index funds and ETFs, review how much the fund charges, known as its expense ratio.
The most important decision you make as an investor isn't which fund to buy. What's essential is your asset allocation, or how much you own of different asset classes, such as stock funds and bond funds.
Stocks are more volatile but have higher returns, and bonds are less volatile with lower returns. Since 1926, stocks of large U.S. companies have returned 10% per year, on average, while bonds have returned more than 6%. A well-diversified portfolio gives a good return with less risk.
When choosing investments, another critical factor is your time horizon, or when you plan to start spending them. That should determine your level of acceptable risk. In the short term, stocks can be volatile. But over decades, they are less risky.
If you're in your twenties and thirties and are investing for retirement in your sixties, you can justify investing virtually all your retirement in stock or index funds. But as you approach and enter retirement, you should invest more cautiously to preserve your wealth. That means owning less stock funds and more bond funds, money-market funds, and other cash savings like CDs.
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Where to buy funds?
You can work with a financial planner who will help you choose funds or use a brokerage with an extensive menu of fund options. I'm a big fan of robo-advisors, like Betterment or Acorns, that offer well-diversified investment options, portfolio rebalancing, more features with low management fees, and access to a human advisor, if needed.
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That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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