A beginner’s guide to mutual funds

A beginner’s guide to mutual funds

Aside from just simply investing in individual stocks, it is possible for you to invest in an index (such as the Nasdaq and Dow Jones) or a mutual fund. The good thing about a mutual fund is that you can get more diversified holdings than you would if you just invested in a single security. However, what exactly is a mutual fund and how do they work? Here, we’ve written up a simple guide for you so that you know exactly what you are getting into.

What is a mutual fund?

Simply speaking, a mutual fund is a financial instrument that pools together the assets from shareholders to invest in other securities like bonds, stocks, money market instruments, and more. Mutual funds tend to be operated by professional money managers. They are responsible for allocating the fund’s assets around. A mutual fund’s portfolio is therefore maintained and structured to follow the investment objectives stated in its prospectus.

As such, by investing in a mutual fund, individual retail investors can easily gain access to a professionally managed portfolio that is diverse and contains equities, bonds, and other such securities. Each shareholder has to participate proportionally when it comes to the fund’s gains and losses.

Why do people buy mutual funds?

So, why do people choose to buy mutual funds then? There are a few reasons why, and below we have listed some of the most popular reasons:

Professional management: Because the fund managers do all the research and allocation for you, you can essentially take a hands-off approach when it comes to monitoring your mutual funds. The fund managers are responsible for selecting the assets as well as monitoring their performance instead.

Diversification: As the old saying goes – don’t put all your eggs in one basket. Fortunately, mutual funds typically invest in a basket of companies and industries. This helps to lower an investor’s overall risk – if one company or industry falls, then the other investments will still be there to help mitigate any losses.

Liquidity: mutual funds are considered liquid because investors can easily redeem and exchange their shares at any time.

Affordability: Most mutual funds tend to be relatively cheap for the initial investment and subsequent purchases.

Types of mutual funds

There are a few different types of mutual funds available for people to invest in, though most of them fall into four main categories. Here are the types below:

Stock funds

These mutual funds primarily invest in stocks or equity. There are also various subcategories, such as small, mid, or large-cap. A few mutual funds are named after their investment approach, such as whether they are aggressive or income-oriented. Mutual funds are also categorised by whether they invest in domestic stocks or foreign ones.

Bond funds

These funds generate a minimum return and are part of the fixed-income category. Fixed-incomemutual funds focus on investments that are sure to pay a set rate of return. These include government bonds, corporate bonds, and other debt instruments.

Others are referred to as bond funds which seek to buy undervalued bonds which will then be sold later. These mutual funds are likely to pay higher returns, though of course with more rewards comes more risk. For instance, a mutual fund focusing on high-yield junk bonds is much riskier than another fund that invests in government bonds.

Balanced funds

These funds tend to invest in a hybrid of asset classes. The main objective of this kind of fund is to reduce the risk of exposure across all asset classes. Some funds may have a specific fixed allocation strategy, while others have a more dynamic allocation strategy. It is important to note that the portfolio manager is given the freedom to switch the ratio of asset classes as needed, in order to maintain the fund’s main strategy. This may mean responding to changes in the business cycle, market conditions, and more.

Index funds

One of the most well-known. This index fundinvests in stocks that correspond with other major market indexes like the S&P 500 or the Dow Jones. This strategy tends to require less research from advisors and analysts, which means fewer expenses passed onto the shareholder. So, these funds tend to be made withcost-sensitiveinvestors in mind.

Advantages of mutual funds

Here are a few other reasons why mutual funds generally have been popular with retail investors in recent years.

Easy access

By trading on major stock exchanges, mutual funds can be bought and sold relatively easily -- so long as one has a brokerage account – which makes them highly liquid investments. Also, when it comes to certain other unique assets (such as foreign equities or other exotic commodities) that might be hard to access on their own, most investors may end up finding them in a mutual fund. Sometimes, that is the only way an investor may be able to participate with that type of asset.

Economies of scale

Mutual funds also provide investors with economies of scale. After all, there arefewer commission fees needed in comparison to if you buy every single asset individually. Buying only one asset at a time also leads to higher transaction fees. Because everything is in one basket, mutual funds can take advantage of dollar-cost averaging.

Transaction costs end up being lower because a mutual fund buys and sells large numbers of securities at a single time. This is lower than what an individual would pay, making it less costly, in the long run, when people choose to invest in them.

Freedom of choice

Investors often have the freedom to research and select from different types of managers with various trading styles and management goals.This can include fund managers focusing on growth investing, emerging markets, value investing, or plenty of other styles. This kind of variety allows investors to gain exposure to bonds, stocks, commodities, and foreign assets, but also real estate as well through certain specialised mutual funds. Mutual funds also provide opportunities for retail investors that may otherwise be inaccessible to them.