Mutual funds, a form of pooled investing, provide a way to combine your money with that of a large group of other investors. The advantage is that pooled investing allows participants to hire professional money managers, thus increasing their prospects of better returns and/or risk management. Other perks include cost sharing among the other investors, and greater diversification as a way to reduce risk.
There are trillions of dollars invested in mutual funds in the United States alone. In fact, to many people, investing means nothing more than buying mutual funds. Originally viewed as a means for the average investor to participate in the stock market, the concept of mutual funds sounds so good on paper. Unfortunately, they haven’t always performed as promised.
It’s over-diversification, stupid!
There is an old saying: “Don’t put your eggs in one basket.” The idea being that if you dropped the basket, you’d lose all of the eggs. The same seemed to hold true for investing: “Don’t put all of your money in one stock (or one segment of the stock market).” It’s best to diversify.
The problem with over-diversification is that it dilutes the return on investment. This is because mutual funds contain so many small holdings in a large number of different businesses. If one or two of these investments pays off big, it doesn’t make much impact on the overall return of the fund.
Oddly enough, prior to the explosion of 401(k) plans, IRA accounts and middle-class investors entering the market, most investors were not overly diversified, nor were they encouraged to be. Investments, by their very nature, balance risk and return. If an investor is seeking a higher return, he or she will need to incur a measure of added risk over time. So the very diversification of mutual fund holdings, while promoting safety in numbers, can also reduce net returns.
What do they know that I don’t know?
People are much smarter investors than they used to be, so having your mutual fund investment nursed by a “professional” money manager can be a double-edged sword. Sure, it’s nice not to be bothered with the day-to-day minutia of managing your portfolio, but if your fund loses money you’ve still got to pay the professional, like it or not. You may know as much or more about managing your money as the professionals, so keep that in mind before pooling your money with others.
There’s always a fee involved
Running a mutual fund costs money. There are the salaries of your professional money handlers to consider, as well as the price of sending out the investor’s monthly statements. As always, the costs of doing business will be passed along to you, and failing to pay attention to these many different fees can have negative long-term consequences (e.g., severe financial penalties).
You’re going to be taxed on your earnings
Whenever your mutual fund manager sells a security at profit for the investors, an immediate capital-gains tax in triggered. If you are are concerned about the impact of taxes on your investment portfolio, remember that there’s no escaping them when it comes to a pooled investment other than putting them to work in a tax-deferred account such as an IRA or 401(k).
Remember, mutual funds are still a safe investment for the average investor, and they historically pay better returns than simply keeping your money in the bank. But there is a downside to them, so do your research before choosing any particular fund.