When I studied Finance in college, mutual funds were criticized a lot by our professors. But when you look at the size of the investments in mutual funds today, they have a lot of capital under their management. So, is the theoretical view of the business college wrong or is it just that people don’t know what they are doing?
It probably is both. Mutual funds do have some very good features for some investors, but they also represent some problems for other investors. I think the decision on whether or not to invest in funds depends on what kind of an investor you are.
Let us first look at the benefits of a mutual fund:
Diversification. A mutual fund has at least millions if not billions to invest in the different investment opportunities that they can choose from. This makes it possible for them to diversify their investment, which is to spread their investments among many different investments. When they diversify, they can reduce the risk of the investment without letting go of a higher return.
Investing small amounts. In a mutual fund, you can usually invest relatively small amounts, without big expenses for trading fees. As a small investor, this is crucial. If, for example, you try to invest in shares of a company with just a small amount, you end up paying a high percentage of your investment in fees.
Professional management. Mutual funds employ professional analysts, who keep an eye on your investment. With the number of opportunities today, it is impossible for the average investor to keep up in his spare time. However, as a whole, mutual funds do perform worse than the market, so it might not be a great benefit.
What are the disadvantages?
Higher expenses. When you invest in a fund, you pay an annual fee for management of the fund – in addition to the trading fees they pay when they trade, and other hidden fees. In the long run, this can significantly decrease your return.
Tax issues. Because you don’t make the decision on which investments to make, it might lead you to paying higher taxes. If they trade a lot, you will end up paying more in tax on your returns, than if you had a passive strategy.
Different objectives. Mutual funds might have different objectives than investors. They might want to trade a lot to earn trading fees, use money to advertise the fund or some other thing that really is not to your advantage as an investor.
My conclusion is that deciding to invest in a mutual fund is an individual issue. You have to weigh the pros and the cons for your specific situation. In general, I think you should choose them if you have funds less than $10,000, but seriously consider handling your own investments if you have more.