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Mutual Funds

Mutual Funds

Mutual funds really captured the public's attention in the 1980s and '90s when mutual fund investment hit record highs and investors saw incredible returns. However, the idea of pooling assets for investment purposes has been around for a long time. Here we look at the evolution of this investment vehicle, from its beginnings in the Netherlands in the eighteenth century to its present status as a growing, international industry with fund holdings accounting for trillions of dollars in the United States alone.

Since their creation, mutual funds have been a popular investment vehicle for investors. Their simplicities along with other attributes provide great benefit to investors with limited knowledge, time, or money.

Diversification

One rule of investing that both large and small investors should follow is asset diversification. Used to manage risk, diversification involves the mixing of investments within a portfolio. For example, by choosing to buy stocks in the retail sector and offsetting them with stocks in the industrial sector, you can reduce the impact of the performance of any one security on your entire portfolio. To achieve a truly diversified portfolio, you may have to buy stocks with different capitalizations from different industries and bonds having varying maturities from different issuers. For the individual investor this can be quite costly.

By purchasing mutual funds, you are provided with the immediate benefit of instant diversification and asset allocation without the large amounts of cash needed to create individual portfolios. One caveat (beware), however, is that simply purchasing one mutual fund might not give you adequate diversification - check to see if the fund is sector or industry specific. For example, investing in an oil and energy mutual fund might spread your money over fifty companies, but if energy prices fall, your portfolio will likely suffer.

The easiest way to understand economies of scale is by thinking about volume discounts: in many stores the more of one product you buy, the cheaper that product becomes. For example, when you buy a dozen donuts, the price per donut is usually cheaper than buying a single one. This occurs also in the purchase and sale of securities. If you buy only one security at a time, the transaction fees will be relatively large.

The easiest way to understand economies of scale is by thinking about volume discounts: in many stores the more of one product you buy, the cheaper that product becomes. For example, when you buy a dozen donuts, the price per donut is usually cheaper than buying a single one. This occurs also in the purchase and sale of securities. If you buy only one security at a time, the transaction fees will be relatively large.

Mutual funds are able to take advantage of their buying and selling size and thereby reduce transaction costs for investors. When you buy a mutual fund, you are able to diversify without the numerous commission charges. Imagine if you had to buy the 10-20 stocks needed for diversification. The commission charges alone would eat up a good chunk of your savings. Add to this the fact that you would have to pay more transaction fees every time you wanted to modify your portfolio - as you can see the costs begin to add up. Mutual funds are able to make transactions on a much larger scale (and cheaper).

Many investors don't have the exact sums of money to buy round lots of securities. One to two hundred dollars is usually not enough to buy a round lot of a stock, especially after deducting commissions. Investors can purchase mutual funds in smaller denominations, ranging from $100 to $1000 minimums. So, rather than having to wait until you have enough money to buy higher-cost investments, you can get in right away with mutual funds.

Another advantage of mutual funds is the ability to get in and out with relative ease. You can sell mutual funds at any time as they are as liquid as regular stocks. Both the liquidity and smaller denominations of mutual funds provide mutual fund investors the ability to make periodic investments through monthly purchase plans while taking advantage of dollar-cost averaging.

When you buy a mutual fund, you are also choosing a professional money manager. This manager will use the money that you invest to buy and sell stocks that he or she has carefully researched. Therefore, rather than having to research thoroughly every investment before you decide to buy or sell, you have a mutual fund's money manager to handle it for you. As with any investment, there are risks involved in buying mutual funds. These investment vehicles can experience market fluctuations and sometimes provide returns below the overall market. Also, the advantages gained from mutual funds are not free: many of them carry loads, annual expense fees and penalties for early withdrawal. In the next article we will take a closer look at some of these drawbacks so you can decide if mutual funds are right for you

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