Mutual funds are managed by experienced professionals who are paid by the fund participants to invest your money for you. One share of a mutual fund entitles you to fractional ownership in every company contained in the fund’s portfolio, as well as your share of all dividends and capital gains that are generated. There is a wide variety of funds available that specialize in various investments such as stocks, money markets, bonds, commodities, foreign investments, precious metals, and real estate. The funds allocate risk by spreading your money around and continually reviewing the performance of the assets in the portfolio.
This is the real advantage of mutual funds over investing in a single stock since owning one stock is analogous to putting all your eggs in one basket. If that one stock fails, you stand to lose all the money you put into it.
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The level of risk is dependent on the type of fund you buy. The most aggressive funds invest in growth stocks of emerging companies that are engaged in pushing the state of the art in their respective businesses. These carry a higher risk since these companies are often unproven and are involved in groundbreaking technologies. The goal of these funds is long-term capital appreciation as the companies grow and prosper, but they are usually the first to be adversely affected by economic downturns. Price volatility is common, which is why they are not suitable for short-term investors.
Funds that invest primarily in large blue chip stocks focus more on dividend income rather than price appreciation. They feature lower risk since these are established companies with proven track records over many years. They are more appropriate for conservative investors and retired people who are dependent on a regular income stream.
Like any investment, mutual funds contain some element of risk since they are not guaranteed like a bank account. The higher the risk you are willing to take, the greater the potential reward if the investment is successful. But the reverse is also true since higher risk exposes you to greater potential losses if the investment sours.
Determining risk level
As a general rule, the younger you are, the higher the risk you are able to assume when investing your money. The reasons for this include the fact that you are years away from having to depend on your savings for everyday life. You are looking for capital appreciation and don’t need current income generation from your investments. Your time horizon is decades, not years, and you can afford to take more risk in order to realize higher returns. If all your investments don’t work out, you have plenty of time to recover.
The risk associated with mutual funds is mitigated by the diversity of each portfolio. The fund is required to send you a prospectus that will show the positions it maintains in every company and how it is weighted by number of shares and current market value. It will also provide a monthly statement that updates the information for each position. While these funds moderate your downside risk, they somewhat limit your expected returns. By diversifying the portfolio, this allows the increased value on some stocks to offset decreases on others. The goal of the fund manager is to ensure that the profits consistently outnumber the losses. You should research the qualifications and past performance of every fund manager to gauge their ability to manage investments in both up and down markets.
How much you invest, for how long, and where you put your money depend on several factors including disposable income, risk tolerance, and age. For most people, the best idea is to start slowly and choose a few different funds to test the water. Young people can absorb more risk and should focus more on growth funds that are banking on the future, rather than value funds that are more appropriate for those relying on dividend income. The best advice is to be careful and thorough before sending your hard-earned cash to anyone else for their safekeeping. Mutual funds are not guaranteed to succeed, and some have been known to fail.
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Classes of shares
Mutual funds that carry a “load” charge a sales commission and annual management fees. The “class” refers to the type of load and how it is applied. Funds with no load are also available which reduce the overall cost to the investor. No-load funds still have management fees, but many are available with very low expense ratios.
Class A shares are front-end loaded which require you to pay the sales commission when you first buy into the fund. This makes sense if the fund is a premier performer and you plan to hold onto the fund for an extended period.
Class B shares are back-end loaded shares which require you to pay the commission when you sell the shares within a specified period. The percentage is calculated on a sliding scale and decreases over time. These shares typically charge a higher management fee to offset the lower commission realized if the shares are held for several years. Some funds allow these shares to be converted to Class A.
Class C shares are level loaded which means the commission is included in the annual management fee. The disadvantage of this is that if you hold the fund for a long time, you pay the load many times over. Generally, these shares cannot be converted.
Importance of historical performance
It goes without saying that no one can predict the future, so choosing a mutual fund is a judgment call. This can be based on many things, and among them is historical performance over an extended period of several years, preferably in a chart format that displays the overall trend. The trend is far more important than looking at the performance in any given year. This stark reality has become more evident in the past year as the stock market as plumbed lows not seen in over a decade. While past performance is not necessarily a reliable indicator of future performance, it does provide you with some assurance that the fund’s management has been able to successfully navigate the ups and downs of the equity markets.
For reference purposes, these are the top ten performing funds over the past five years:
