Mutual Funds

You have decided to invest, but maybe you are not comfortable trading stocks on your own. Alternatively, maybe you simply do not want to invest the time in researching investments and would rather pay a professional to handle that part of the investment process. Regardless of your motives, mutual funds are a great way to diversify your portfolio, limit the amount of time and effort you commit to making investment decisions, and meet your financial goals.

What is a mutual fund?

Mutual funds are professionally managed investment funds. The fund manager will determine when to shift assets and the best time to buy and sell. You benefit from diversification because the fund will hold a pool of different investments (stocks, bonds, real estate, etc.). The pool will typically be larger than what you would be able to acquire on your own. By pooling your money with other investors in the mutual fund, your combined purchasing power allows for large holdings in numerous assets. Thus, if one stock is struggling in a particular quarter or year, the other stocks that are profiting will offset the loss.

A subset of mutual funds is index funds, which mirror a particular index. For example, if you pick an S&P 500 index fund, the fund manager for that index fund will choose investments that mirror those in the S&P 500. As a result, you can expect similar returns to the stock market by investing in that fund.

What should I look for when picking a mutual fund?

At this point, hopefully you see the value in a mutual fund, but do not just go purchase the first mutual fund you see. Not all mutual funds are created equal. That being said, what factors are important to consider when choosing a mutual fund?

Long-term Performance: Long-term performance is the first metric to consider. A fund may have performed well above the market last year. However, if the previous five years were all losses, then the fund probably is not the best pick. I recommend looking at the 10-year performance when choosing a fund. Short-term losses and gains are largely irrelevant. You should be investing for the future, so do not get caught up in small changes now, plan for the future.

Expense Ratio: The expense ratio is also important. Every mutual fund will have a fee that you pay to have a professional fund manager oversee your investments. The expense ratio will be expressed as a percentage. The smaller the percentage, the better, as this means your fee is smaller. For example, an expense ratio of 0.2% is better than 0.4%. While a fraction of the percent may seem insignificant, you have to remember this impact is compounded over time. The more you pay in fees, the less money you have available to make more money. Use a compound interest calculator, and you will quickly see the benefits of compounding – one of the most important investment principles.

Risk and Goals: Additional considerations when picking a mutual fund are the amount of risk you are willing to accept and your future goals. While mutual funds reduce risk by diversifying, a mutual fund that is diversified in all risky investments is still risky. Therefore, consider the underlying investments held in the fund. Look at the top holdings (those investments that make up the largest percentage of the mutual fund) and determine if those holdings seem prudent to you. Additionally, if you are close to retirement or plan to pull out some of the funds for a larger purchase, you may be willing to accept slightly lower returns in order to protect your principal from sudden or drastic changes.

Conclusion

Mutual funds are a great option for many investors. They allow you to take advantage of professional fund management with minimal fees. However, picking the right mutual fund for you is an important decision. Warren Buffett recommends an S&P 500 index fund for average investors, and this is what I recommend to my family and friends. The key is consistency. Do not just put one lump sum in the mutual fund and never touch it again. Decide on an amount that you can afford each month, and consistently contribute. If you do this, you will be amazed at the growth. Remember, it takes time, but if you exercise the discipline now, you will reap the rewards 5, 10, and 30 years down the road.