Investing in Mutual Funds
There are 4 types of investments that are great for beginner investors:
What are mutual funds?
A mutual fund is a collection of different investors' money. This is pooled together to invest in a shared portfolio of stocks, bonds and other securities.
You, the investor, would own a fraction of the shares in proportion to the amount you invested. If you invested $1,000 in a $100,000 fund, your stake would be 1%. As the size of the fund increases, your percentage will decrease - unless you continue to invest more.
How can you profit from investing in mutual funds?
A money manager controls the mutual fund. They can either be an individual or a large company.
Their goal is to make as much money as possible for their investors.
The money that a mutual fund shares with its investors is called a distribution. There are two ways that money can be added to the distribution:
- When a person or a fund invests in a company’s stock, the company can pay out dividends. A dividend is an amount of money, usually drawn from profits, that the company has decided to share with its shareholders. Investors can choose to receive a check or to reinvest the money in the mutual fund.
- The fund can choose to sell shares it owns if the price has significantly increased. This results in a profit for the investors.
If the fund has increased in value, you can also choose to sell your own stake in the fund. Hopefully, for more than you initially paid.
Benefits of investing in mutual funds
Even though you are investing in one fund, you aren’t putting all your eggs into one basket. Most mutual funds will invest in hundreds of different securities. This makes them an easy method of spreading risk through portfolio diversification.
It's just as easy to invest in one mutual fund as it is to invest in a single stock, but your money is stretched much further. If one of the securities in the mutual fund begins to fail, its effect could be outweighed by the rest of the fund.
Access all areas
Mutual funds have access to investments that individual investors do not. This could include foreign equities, or securities that need a large initial buy-in.
Mutual funds are run by professional money managers who (should) know what they’re doing. You can rely on the fact that, at this point in your investing journey, they will have more experience than you.
Negatives of investing in mutual funds
Although cheaper than personal financial advisors, mutual funds still have pretty high fees. Some funds charge an annual fee to cover administration costs. Others are commission-based, meaning they take a percentage of your investment in the fund.
You must pay the fees, regardless of how well or badly the fund is doing. Meaning you could essentially pay to lose money.
Lack of control and transparency in holdings
You can choose the type of the mutual fund, perhaps growth or dividend focused. But you cannot choose the indivudual investments.
This means that you could unknowingly be investing in companies you wouldn’t want to endorse.
If you decide to sell your holding, the fund needs to have the cash available to pay you. This means that a large chunk of the fund’s capital (your money) needs to be held as cash.
This is known as a cash drag and, as we know, cash that’s just sitting around won’t be making you any money.