The simple answer to the question ‘why should I buy a mutual fund?’ recalls the proverbial joke about the chicken crossing the road. The answer, ‘to get a good return on my investment’, or even more simply ‘to make money’ seems so obvious as to be almost an insult to one’s intelligence. But mutual funds are just one of a variety of potential investment vehicles. Stocks, bonds, and other investments that are available for purchase also offer the potential to make money. So what makes mutual funds the investment of choice for many? When you boil it down, mutual funds provide three major benefits for those who decide to invest in them:
1. Diversification, 2. Expertise, .. and 3. Time
What do each of these mean?
Diversification: In times of high volatility and risk, owning one, two, or even five different stocks, bonds, or whatever security you’d like to invest in can be risky in that there is simply no guarantee that your picks are going to be winners. Mutual funds, on the other hand, offer risk diversification. This means that funds purchase more than a few different investments and the risk of losing significantly in any one investment is minimized by being distributed over a number of investments.
Expertise: You can be fairly certain that professional mutual fund managers have more research, knowledge, connections, and experiences at their disposal than you do. However, expertise and resources don’t always produce stellar results. In fact, only 31% of actively managed stock-based mutual funds outperformed the S&P 500 over the five years ending Dec. 31, 2008. That’s why many investors choose index mutual funds as an alternative to actively managed funds. Index funds simply aim to match the performance of the index that they are following. Since index funds don’t have professionals choosing the investments, their fees tend to be lower than actively managed funds. Whether you choose index or actively managed funds, you are paying for the expertise and convenience offered by those funds.
Time: Without professional resources at your disposal, successful investing can take an extreme amount of time and energy. There is a very high learning curve involved in investing that few have enough time to pick up. If you opt to buy more investments in order to diversify, your time commitment only increases. Opting to put your money into mutual funds frees the time that it takes to research and keep up with each of your individual investments.
How to Purchase a Mutual Fund
If you’ve determined that you want to purchase a mutual fund, here’s how you can do it, step-by-step.
1. Choose a discount brokerage (i.e. Zecco, Scottrade, Etrade, Fidelity, Schwaab, etc.) to purchase your fund through. You could opt to invest in mutual funds through a full service advisor, but there is a wealth of comparative resources available to help you choose your fund for free so that you can purchase through a low fee discount broker instead.
2. Start an investment account through your broker. This could be a a general trading account or a retirement account such as a Roth IRA or Traditional IRA.
3. Research. In an upcoming post, we’ll highlight what you should look for in a mutual fund. For starters, you may want to focus on choosing a fund that consistently has at least met and preferably beat the performance of its peers at a fee that is lower than its peers.
4. Fund your Account: You must send in money via check, wire, or other deposit to your discount broker. Once your account has funds available, you can make your mutual fund purchase.
5. Make your Purchase. Enter a dollar amount that you’d like to apply towards the fund. This differs from entering a price you want to pay as you do when you purchase a stock. The price you will pay for each share will be the closing price on the day that you purchase the fund. The amount you enter will be divided by that share price to determine how many shares of the fund you will receive. When you first purchase a fund, you need to indicate whether you would like your dividends, capital gains, or both reinvested into additional shares. You can change this election at a later time. There is little reason not to choose ‘both’.
Some funds offer no transaction fees when you make a purchase. For those that do charge a fee (typically $25-50) you do not have to pay this fee when you purchase additional shares of the same fund. It’s also worth noting that many funds require a minimum initial purchase that depends on what type of investment account you are using.
6. Add to your Shares Over Time at your Discretion
For more of GE Miller’s writing, visit personal finance blog 20somethingfinance.com.