One of the best financial instruments to get started as an investor are mutual funds.
How a mutual fund operates
An investment company solicits investments from many investors. Those investments can be as small as $25 per month. This is what makes mutual fund so appealing, that it is within the reach of practically anyone who can put together a small amount of money.
The money collected is is used to make investments, generally of stocks, but also bonds and other securities. A professional mutual fund manager is the person in charge of making daily investments decisions.
Having a large pool of money allows the money manager to diversify into many investments. Small investors generally don’t have the capital to invest in hundreds of different companies. Also, small investors don’t have the time nor expertise to research hundreds of companies.
Different focus of mutual funds
Many mutual funds companies have different focus of interest. For example, some funds may invest in technology companies, other funds may invest in dividend paying stocks, other may invest is small stock. It is up to the investor to decide which of those investments philosophies he/she prefers and then buy the mutual fund which reflects that philosophy.
Advantages of mutual funds
One of the big advantages of mutual funds is the elimination or reduction of single stock risk. Those who once owned Nortel, Enron, or Blackberry are well aware of the single stock risk. Single stock risk exist when an investor can lose a significant amount of money because the single stock they own, has a big decline in price. By having hundreds of stocks, the single stock risk is greatly diminished.
Disadvantages of Mutual funds
However, mutual funds are risky and many of them could do so bad that they could be closed down. It is quite possible to lose 50% or more of your money when investing in mutual funds.
Another big disadvantage of owning mutual funds is their high fees. Canada has one of the highest mutual funds fees in the world. While you, the investor, are putting your money at risk, the mutual fund company could easily eat away more than 50% of your profit. It’s very important to make sure your fees are low. Most Canadian mutual fund charge between 2% to 3% in fees. This is outrageous, they should be ashamed of themselves, but is it also, the generally public faults.
Side note: I have a friend, who continues investing in expensive mutual funds because the mutual fund salesperson invited him to a nice steak dinner.
Look for low fee index funds
If you are interested in mutual funds, make sure you don’t pay more than 1% in management fees. There are many alternatives out there.
It has been proven over time that most active managers don’t beat the benchmark to which their funds are compared. For example, a Canadian mutual fund may be compared to the Canadian stock market index. Most mutual fund don’t beat their benchmark because of their high fees or because of many other mutual funds inefficiencies.
The solution to diversify your investment and pay a low fee is to invest in a mutual fund which follow the national index. For example, in Canada, I would invest in a mutual fund which follows the the Toronto Stock Exchange 300. In the US, I would invest in a mutual funds which follows the S&P 500. The fee for this kind of funds is generally 0.10% or less.
Historically the US market and Canadian market have grown at the rate of over 8% per year. If you subtract the index fund expense of 0.10% then you will be left over with a profit of 7.9% or more. This is a more interesting scenario than paying 2 to 3% in fees to a mutual fund a mutual fund manager.