Mutual Funds: Know the Advantages and Disadvantages

About Mutual Funds


With all advantages and disadvantages, mutual funds as category of investments have become extremely popular over the last 20 years. What was once just another obscure financial instrument is now a part of our daily lives. More than 80 million people, or one half of the households in America, invest in mutual funds. That means that, in the United States alone, trillions of dollars are invested in mutual funds.


Originally, mutual funds were heralded as a way for the little guy to get a piece of the market. Instead of spending all your free time buried in the financial pages of the Wall Street Journal, all you had to do was buy a mutual fund and you'd be set on your way to financial freedom. As you might have guessed, it's not that easy. Mutual funds are an excellent idea in theory, but, in reality, they haven't always delivered. Not all mutual funds are created equal, and investing in mutual funds isn't as easy as throwing your money at the first salesperson who solicits your business.

Still, for the individual investor, mutual funds provide the benefit of having someone else manage your investments, take care of recordkeeping for your account, and diversify your dollars over many different securities that may not be available or affordable to you otherwise. Today, minimum investment requirements on many funds are low enough that even the smallest investor can get started in mutual funds.

A mutual fund, by its very nature, is diversified -- its assets are invested in many different securities. Beyond that, there are many different types of mutual funds with different objectives and levels of growth potential, furthering your chances to diversify.

Introduction to Mutual Funds


When you invest in a mutual fund, your money is combined with the money of many other investors. Professional fund managers use this pool of money to create a portfolio of investments, which may include:
§         Stocks: ownership shares in publicly held companies
§         Bonds: interest-bearing certificates issued by governments and corporations 
§         Money Market Securities: short-term instruments, such as U.S. Treasury bills and certificates of deposit, that matures in less than one year.

Each mutual fund has specific investment goals that can range from long-term growth to current income. In addition, a fund may invest in specific types of investments to reach its goals, such as dividend-paying stocks, international investments or long-term bonds.

Owning shares of a mutual fund is similar in some ways to owning shares of stock in an individual company. The mutual fund company will ask you to vote for its board of directors and to help determine other company matters. The mutual fund also may pay you dividends from the securities in which it invests or capital gains that the fund made from selling securities.


You can make money from a mutual fund in three ways:
1) Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution.
2) If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
3) If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. You can then sell your mutual fund shares for a profit.

Funds will also usually give you a choice either to receive a check for distributions or to reinvest the earnings and get more shares.

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Meaning of Share Price and Total Return


A mutual fund’s share price, which is referred to as its net asset value or NAV, is determined at each day’s market close. The price reflects the closing value of all of the investments the fund holds in its portfolio on that day.

Like stocks, the daily price of a mutual fund may go up or down. A fund’s share price can give you an idea of how a fund is performing on a day-to-day basis.

A fund’s total return shows you how much the fund’s shares appreciated or depreciated over the long term and takes into account any distributions of dividends or capital gains. Total return generally is stated as an annual percentage rate.


20 Benefits of Mutual Funds

1. Professional Investment Management.
By pooling the funds of thousands of investors, mutual funds provide full-time, high-level professional management that few individual investors can afford to obtain independently. Such management is vital to achieving results in today's complex markets. Your fund managers' interests are tied to yours, because their compensation is based not on sales commissions, but on how well the fund performs. These managers have instantaneous access to crucial market information and are able to execute trades on the largest and most cost-effective scale. In short, managing investments is a full-time job for professionals.

2. Diversification.
Mutual funds invest in a broad range of securities. This limits investment risk by reducing the effect of a possible decline in the value of any one security. Mutual fund shareowners can benefit from diversification techniques usually available only to investors wealthy enough to buy significant positions in a wide variety of securities.

3. Low Cost.
If you tried to create your own diversified portfolio of 50 stocks, you'd need at least $100,000 and you'd pay thousands of dollars in commissions to assemble your portfolio. A mutual fund lets you participate in a diversified portfolio for as little as $1,000, and sometimes less. And if you buy a no-load fund, you pay no sales charges to own them.

4. Convenience and Flexibility.
You own just one security rather than many, yet enjoy the benefits of a diversified portfolio and a wide range of services. Fund managers decide what securities to trade, clip the bond coupons, collect the interest payments and see that your dividends on portfolio securities are received and your rights exercised. It's easy to purchase and redeem mutual fund shares, either directly online or with a phone call.

5. Quick, Personalized Service.
Most funds now offer extensive websites with a host of shareholder services for immediate access to information about your fund account. Or a phone call puts you in touch with a trained investment specialist at  a mutual fund company who can provide information you can use to make your own investment choices, assist you with buying and selling your fund shares, and answer questions about your account status.

6. Ease of Investing
You may open or add to your account and conduct transactions or business with the fund by mail, telephone or bank wire. You can even arrange for automatic monthly investments by authorizing electronic fund transfers from your checking account in any amount and on a date you choose. Also, many of the companies featured at this site allow account transactions online.

7. Total Liquidity, Easy Withdrawal
You can easily redeem your shares anytime you need cash by letter, telephone, bank wire or check, depending on the fund. Your proceeds are usually available within a day or two.

8. Life Cycle Planning
With no-load mutual funds, you can link your investment plans to future individual and family needs -- and make changes as your life cycles change. You can invest in growth funds for future college tuition needs, then move to income funds for retirement, and adjust your investments as your needs change throughout your life. With no-load funds, there are no commissions to pay when you change your investments.

9. Market Cycle Planning
For investors who understand how to actively manage their portfolio, mutual fund investments can be moved as market conditions change. You can place your funds in equities when the market is on the upswing and move into money market funds on the downswing or take any number of steps to ensure that your investments are meeting your needs in changing market climates. A word of caution: since it is impossible to predict what the market will do at any point in time, staying on course with a long-term, diversified investment view is recommended for most investors.

10. Investor Information
Shareholders receive regular reports from the funds, including details of transactions on a year-to-date basis. The current net asset value of your shares (the price at which you may purchase or redeem them) appears in the mutual fund price listings of daily newspapers. You can also obtain pricing and performance results for the all mutual funds at this site, or it can be obtained by phone from the fund.

11. Periodic Withdrawals
If you want steady monthly income, many funds allow you to arrange for monthly fixed checks to be sent to you, first by distributing some or all of the income and then, if necessary, by dipping into your principal.

12. Dividend Options
You can receive all dividend payments in cash. Or you can have them reinvested in the fund free of charge, in which case the dividends are automatically compounded. This can make a significant contribution to your long-term investment results. With some funds you can elect to have your dividends from income paid in cash and your capital gains distributions reinvested.

13. Automatic Direct Deposit
You can usually arrange to have regular, third-party payments -- such as Social Security or pension checks -- deposited directly into your fund account. This puts your money to work immediately, without waiting to clear your checking account, and it saves you from worrying about checks being lost in the mail.

14. Recordkeeping Service
With your own portfolio of stocks and bonds, you would have to do your own recordkeeping of purchases, sales, dividends, interest, short-term and long-term gains and losses. Mutual funds provide confirmation of your transactions and necessary tax forms to help you keep track of your investments and tax reporting.

15. Safekeeping
When you own shares in a mutual fund, you own securities in many companies without having to worry about keeping stock certificates in safe deposit boxes or sending them by registered mail. You don't even have to worry about handling the mutual fund stock certificates; the fund maintains your account on its books and sends you periodic statements keeping track of all your transactions.

16. Retirement and College Plans
Mutual funds are well suited to Individual Retirement Accounts and most funds offer IRA-approved prototype and master plans for individual retirement accounts (IRAs) and Keogh, 403(b), SEP-IRA and 401(k) retirement plans. Funds also make it easy to invest -- for college, children or other long-term goals. Many offer special investment products or programs tailored specifically for investments for children and college.

17. Online Services
The internet provides a fast, convenient way for investors to access financial information. A host of services are available to the online investor including direct access to no-load companies.

18. Sweep Accounts
With many funds, if you choose not to reinvest your stock or bond fund dividends, you can arrange to have them swept into your money market fund automatically. You get all the advantages of both accounts with no extra effort.

19. Asset Management Accounts
These master accounts, available from many of the larger fund groups, enable you to manage all your financial service needs under a single umbrella from unlimited check writing and automatic bill paying to discount brokerage and credit card accounts.

20. Margin
Some mutual fund shares are marginable. You may buy them on margin or use them as collateral to borrow money from your bank or broker. Call your fund company for details.

4 Disadvantages of Mutual Funds:

1.      Professional Management.
Did you notice how we qualified the advantage of professional management with the word "theoretically"? Many investors debate whether or not the so-called professionals are any better than you or I at picking stocks. Management is by no means infallible, and, even if the fund loses money, the manager still takes his/her cut. We'll talk about this in detail in a later section.

2. Costs.
Mutual funds don't exist solely to make your life easier - all funds are in it for a profit. The mutual fund industry is masterful at burying costs under layers of jargon. These costs are so complicated that in this tutorial we have devoted an entire section to the subject.

3. Dilution.
It's possible to have too much diversification. Because funds have small holdings in so many different companies, high returns from a few investments often don't make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money.

4. Taxes.
When making decisions about your money, fund managers don't consider your personal tax situation. For example, when a fund manager sells a security, a capital-gains tax is triggered, which affects how profitable the individual is from the sale. It might have been more advantageous for the individual to defer the capital gains liability.


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