Remember that earlier article about diversification in your
investments? Mutual funds are a great tool to achieve diversification without
investing a great deal of money. There are many types of them out there but the
main benefit remains the same – that is to pool money together so that instead
of investing into one company, you can afford to own shares of a number of
companies. If an average investor were to invest on their own without pooling
cash, she can probably only afford to invest in a handful of companies because
if she had spread it out too thin, it's no longer worth it given the commission
on each transaction. Another reason it is not feasible is because the shares are
usually sold in board-lots (a term used to describe a chunk of 100 shares of
any company), buying a smaller portion may incur extra fees. By pooling cash
using a mutual fund, investors can have a stake in many more companies without
incurring the extra charges and commission fees themselves. What's the down
side? Well... with the huge amount of diversification and less volatility, you
will usually not earn as much as investing into a few stocks on your own.
Now I know many of you don't have the time to read through my
paragraphs, and I don't intend on putting you to sleep so here's the Spark
Notes version:
Why might you want a mutual fund?
- Achieve diversification without investing a large amount of money
- You want to save a portion of each paycheque (aka. paycheck), and a mutual fund allows for smaller investments
- You don't have time to manage your investments
- You want a professional to pick specific investments for you (eg. Pick stocks within a mutual fund)
Why might you not
want a mutual fund?
- You want to take on more risk in exchange for a higher return
- You like to be in control of which companies you invest in, maybe the thought of investing into a company named after a fruit makes you feel uneasy, or [insert reason here]
- You don't like the restrictions placed on when you can sell it (some funds will charge you a fee if you sold any portion of it within 30 days of the most recent purchase)
- Diversification in a mutual fund is too much for you, you want to keep it to a smaller portfolio
Now that you have seen the good and the bad, what's the
ugly? Here it is – the fees! Within a mutual fund there are a lot of
transactions made by the investment manager and all those cost the fund money,
which then gets transferred to you as the investor. In addition you also have
to compensate the fund manager, which you would not have had to if you invested
in companies on your own. To make it even costlier, some funds will charge you
a fee upfront or at the end when you sell it (called front-end and back-end
load respectively). We will get to fees in another article later but for now
just know that although you don't pay the fees directly, there are lots of
costs in the background that sometimes can be more than the commissions you
would incur from trading shares on your own!
In the next article we will explore different types of
mutual funds out there, and help you decide which one is right for you
Happy investing!
-TT
