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What Are Mutual Funds?

Mutual funds, which were started in Boston in 1924, are a basket of securities, such as stocks and bonds, managed by a professional fund manager on behalf of people who buy shares in the fund. Professional management fund companies charge a management fee and various fund expenses, which generally range from 0.5 percent to 1.75 percent per year. This fee is deducted periodically from the overall fund assets whether the fund has gains or losses for any given period.

Mutual funds have developed into important investment vehicles for U.S. households. They provide a low-cost way for investment as they typically have low minimum investment requirements to start, such as $2,500. Without mutual funds, investors are faced with having to invest in individual stocks or bonds, priced individually. Shares may be priced high, (e.g., like with Google or Apple), meaning an investor with limited investment resources could only purchase those high-priced shares in very small numbers, pay the transaction costs for each purchase. That same investor interested in technology stocks can buy a professionally managed technology fund with $2,500 to start with the investment spread over hundreds of stocks, thereby mitigating concentration risk.

Professional money management is one of the features that make mutual funds so attractive to investors, particularly for the many individuals who have neither the time nor the resources to study the securities markets, evaluate economic trends, and develop a portfolio that meets their financial objectives.

Mutual funds are “great enablers.” The mutual fund industry has contributed to the financial well-being of millions of mutual fund shareholders, as well as to economic growth through its effect on money and capital markets. Among other things, it has enabled millions of Americans to invest in stocks and bonds in their retirement accounts, diversifying their investments across a wide swath of securities, thereby reducing risk. There are many types of funds, some focused on capital appreciation (i.e., long-term investing), and some that are structured to derive income from investments, such as receiving periodic payments of stock dividends and bond fund distributions.

Picking mutual funds is complicated. Two websites I recommend for research are morningstar.com and investopedia.com. There are stock funds and bonds funds and those which mix the two. Essentially, consider the following:

  • Your investment objective and time horizon: There is always a trade-off between risk and reward when it comes to investing. There are many types of funds out there, some invest in riskier small-cap stocks (long-term investing), some in steadier large caps. Some funds are “balanced,” which means stocks and bonds are mixed in various proportions. Designed to be “balanced,” they perform in all types of market environments.
  • Fund performance in the past three, five, 10 years: How does it compare to similar funds in it’s category and against it’s benchmark? Research this on websites such as Morningstar. They provide extensive information and ratings on the fund — its manager, parent company stewardship, investments, sectors and asset classes (what types of securities it invests in), regional information, potential risks, etc.
  • Fees and expenses: Extensive research has shown that funds with the highest expenses tend to perform poorly long-term. Look for low-cost funds in general.
  • Fund age and size?
  • Fund’s portfolio turnover: The frequency of buying and selling of securities (this may affect tax efficiency).

These are simple examples to consider when picking a mutual fund. As of 2012, there are more than 7,500 mutual funds in the U.S., and it is crucial to do careful and extensive research into which fund deserves your investment.

Michael Philips is the founder and owner of Financial Mastery Wealth Management and a Registered Investment Advisor in California. With more than 14 years of experience in investing and portfolio management, and having weathered the two worst bear markets since the Great Depression, he has gained a disciplined perspective on investing, and holds the professional designations: Accredited Wealth Management Advisor and Chartered Mutual Fund Counselor. Financial Mastery Wealth Management manages investment portfolios and designs comprehensive financial plans for high-net worth individuals, families and businesses as they pursue their pursue their financial goals, protect and grow their wealth.

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