Investing in Mutual Funds: The Basics
It is quite easy to complicate matters involving mutual fund investments. However, if you are a beginner (and we all were at some point), you would probably prefer a basic, easy-to-understand guide. Let’s start by answering some basic questions regarding mutual funds.
- What is a mutual fund?
A mutual fund enables you to invest a sum of money along with many hundreds, if not thousands, of other people like yourself in a portfolio of shares, stocks, real estate, bonds, and other securities and to be allocated a portion of the total amount invested. For instance, let us assume that there are 100 investors, including yourself, who have invested a total of $5 million, and you have personally invested $25,000 of this money. In this case, you own 1/200th of the portfolio, which is managed by an experienced fund manager who will make decisions on your behalf, e.g., regarding which stocks to buy or sell.
- How much can you invest in a mutual fund?
The amount that you can invest in a mutual fund varies among different mutual fund providers. However, you can usually invest anywhere from only a few hundred up to millions of dollars. A mutual fund therefore allows an investor who has a relatively small amount of money to invest in a diverse range of investments in a cost-effective way.
For instance, if you had $1,000 to invest in stocks and shares, it would not be practical to invest that sum in 50 different holdings. It would also cost a great deal in stock broking fees whereas with a mutual fund, this level of diversification is perfectly achievable. By doing so, you are spreading the risk so that if one particular sector of the stock market suffers, any of your monies held in that sector may suffer, while the rest of your funds invested in other shares outside of that sector may still be flourishing.
- What level of risk can you take in a mutual fund?
There are various types of mutual funds, each with different levels of risk. This enables you to match your level of risk with a particular fund. You can actually invest in more than one of the funds, thus allowing you to invest, for instance, 50% of your monies in a low-risk fund, 25% in a medium-risk fund, and 25% in a high-risk fund.
Below are some of the types of funds available:
- Money market funds
These are low-risk funds investing your money in fixed-income securities offered by the likes of the U.S. government and large, well-regarded corporations. They usually mature in a short period of time. Your funds benefit from the interest paid by these securities, but they are not designed to increase their capital value—in fact, they are geared towards returning the same amount that was originally invested.
- Bond funds
These also tend to be classed as low-risk investments although there are different types of fixed-income securities. For instance, a high-yield bond is more of a risk than a municipal, corporate, or government bond, as the provider is more likely to default. Bond funds can invest in bonds in different parts of the world.
- Stock funds
Stock funds vary from low to high in risk depending upon the type of common stocks in which each particular stock fund invests. For instance, one fund may invest in U.S. securities, another may invest in a mixture of U.S. and overseas securities, and yet another solely in overseas securities.
A stock fund can also focus on investing in a specific sector or industry, such as banking or eco-friendly securities. The latter is viewed as a high-risk investment because the companies in which funds are invested tend to be the likes of businesses involved in such things as solar panels and wind farms, which are fairly recent innovations. A stock fund can also contain securities geared towards producing an income or growth.
- Hybrid funds
Hybrid funds can be low-, medium-, or high-risk funds depending upon where the monies are invested. An example of a hybrid fund is what is called a "fund of funds,” whereby the fund is comprised of investments in several of the provider’s other funds, as referred to above.
Yes, it does. Management fees are required based upon a percentage of the fund’s value; therefore, it is in the best interest of the fund manager to manage a fund that is performing well. There are other charges covering such things as the buying and selling of stocks.
You most certainly can. As well as investing monies in stocks that are designed to provide capital growth, mutual funds invest in stocks that are designed to pay a high level of income by way of dividends. If you require an income, your funds can be invested in the income-producing funds.
You can invest both lump sums and/or pay into a mutual fund on a monthly basis. With regard to monthly contributions, these can be as small as $100 with some companies.
Your money is extremely accessible. Therefore, if you needed access some or all of the money in an emergency situation, you could do so within a few days. Having said that, you should not consider investing in mutual funds unless you are prepared to invest for a period of five years or more to, hopefully, weather the storm of the highs and lows of stock markets.
Ideally, yes. You should get advice from an independent financial advisor who will be able to recommend a suitable fund based on a number of factors that your advisor has obtained about you.
Your advisor will undertake a thorough review of your personal financial circumstances. This includes establishing the amount you have available to invest having taken into account how much you need to keep in an instant-access savings account to cover emergencies, the period for which you would like to invest the money, the level(s) of risk you are prepared to take, and whether you wish to invest for capital growth, income, or a mixture of both.
Your advisor will also explain in detail each fund that is being recommended to you, i.e., U.S. and/or overseas stocks and the sectors the funds invest in so that you are fully aware of what your money is being invested in and the level of risk you will be taking.
There are a number of places where you can arrange such investments: directly with a fund company as well as through your bank, an investment firm, insurance companies, and brokerages.
Your independent financial advisor will also be able to deal with all the paperwork in connection with applying to invest in a mutual fund.
You most certainly can, and many clients already do this. It is another way of diversifying even further—the performance of one mutual fund company can differ from that of another.
With so many funds to choose from, a mutual fund allows you to diversify and explore a range of different investment opportunities, both within the U.S. and overseas, thus enabling you to minimize your risk and maximize your potential gain.