Mutual Funds - A valuable investment tool

by Gene Walden

Perhaps you have heard of mutual funds or invest in some yourself, but do you really know what they are? Do you know how this investment tool compares to others, or how to choose the right fund for you? Read our guide. Then, talk to your financial professional and decide if mutual funds have a place in your investment toolbox.

During the past 25 years, mutual funds have helped millions of Americans save for their future goals. But what exactly is a mutual fund?

In simple terms, it’s a group of stocks, bonds or other investments that is managed by a financial expert (or group of experts). So, when you buy “shares” of a mutual fund, you are essentially buying a piece of each of the stocks, bonds or other investments that the mutual fund owns and the experts manage.

“Think of a mutual fund as a bucket,” explains Darrell Shideler, a financial representative with Thrivent Financial for Lutherans. “You, as the investor, own a piece of that bucket. The bucket can be filled with various items such as stocks, bonds or cash. And the value of those items gives value to the bucket. Although you do not own the items in the bucket, you do own a piece of the bucket and its proportionate value.”

Many people invest in mutual funds as part of a retirement savings plan, such as an IRA or 401(k). In fact, company 401(k) plans often let employees choose from several mutual funds to use within their account. Other people invest in mutual funds to save for college, a down payment on a home or another major expense in their future.

How do mutual funds stack up to other investment options? Their benefits include:

• Diversification. Being “diversified” means owning many different investments. While a single stock or bond may go through large price swings, a diversified group of stocks or bonds can provide more stable returns.“An individual investor may need at least 30 to 40 different stocks in her portfolio to be truly diversified,” says David Francis, head of equities for Thrivent Asset Management. “That would require a lot of money and a lot of time.” But by investing in mutual funds—which usually hold dozens, if not hundreds, of stocks or bonds—that investor can create a far more diverse portfolio more cost effectively.
• Expertise. Mutual funds are managed by investment experts who follow the markets and decide which stocks or bonds to buy or sell—and when. “If you hold 100 stocks as an individual, you have to know when to sell those stocks and buy others,” says Shideler. “With a mutual fund, the manager makes those decisions for you.” Once you’ve done the paperwork and deposited your money, your work is done. You only need to make a change if your investment goals change.
• Flexibility. “Mutual funds also make it easy to buy and sell,” says Shideler. With the majority of mutual funds, you can sell your shares at any time. However, you should consider collaborating with both your financial and tax professionals about the possible tax implications or penalties that may apply to your situation.
• Affordability. Even though mutual funds are packed with investments and managed by experts, you don’t need a lot of money to buy shares—usually about $500 to $3,000 up front, depending on the fund. Once you have a fund account, you often can continue to contribute even smaller amounts ($50 to $100 at a time, for example). And nearly all funds allow you to have a set amount of money automatically withdrawn from a bank account and invested at intervals, such as monthly, quarterly or yearly.

To decide which mutual fund is right for you, ask your financial professional.

What kind of fund is it? “You need to find out if it’s a stock fund, a bond fund, a small-company fund, a foreign stock fund, etc.,” says Francis, since each kind of fund can do something different for you money-wise.

For instance, if you need income to help pay your bills, you could invest in a bond fund that pays interest periodically. If you hope to see your money grow, you could invest in a stock fund. Consider your goals and then choose funds that will help you get there.

How has the fund performed? Just because a fund has made money in the past doesn’t mean it will continue to make money, and at the same rate. “You’re always buying the performance someone else got,” says Francis, “but a fund’s past performance is still a valid way to measure the fund manager’s ability.” As you evaluate that past performance, you should look at their experience during both volatile and good markets. Keep in mind, however, that past performance does not indicate or guarantee future results. Your financial professional likely will recommend a mutual fund with a management team that is suitable to your goals.

What is my risk tolerance? Answering this question may take some honesty on your part. Are you willing to hold on to your investments if the stock market drops and take advantage of the opportunities for gains when it recovers? Or, would you prefer to see your balance grow more slowly, with fewer dips? If you’re not sure, talk to your financial professional. “He or she is there for two reasons—to keep you from getting too greedy and to keep you from panicking,” says Shideler.

What else should one keep in mind with this investment tool? Mutual funds also involve:

• Risk: With almost all mutual funds, there’s a chance you could lose money. Unlike bank savings accounts or CDs, mutual funds are not guaranteed or insured by the Federal Deposit Insurance Corp. (FDIC) or any other government agency.
• Taxes: If you’re in a high tax bracket, work with your financial and tax professionals to verify your investments meet your needs, such as considering mutual funds that keep your capital gains taxes to a minimum. “He or she should be able to help you build the appropriate mix of cash, stock and bond funds,” says Shideler.
• Fees: Mutual funds all charge a fee to cover their costs. Some also assess a sales charge or “load”—the industry term for the fee that may be associated with a mutual fund share transaction. This sales charge primarily relates to services a financial professional brings to the table, such as risk tolerance testing, asset allocation advice and ongoing account assistance. No-load funds—those without a sales charge—typically do not provide access to a financial advisor.

Remember, your financial representative can help you understand all of the costs associated with different types of investment options and find the ones that best fit your needs.

Gene Walden is a nationally known finance writer living in Eden Prairie, Minnesota. He has published more than a dozen books on business and investing.

Learn More:
Mutual Fund Documents | Finding Steady Funds