How Do Mutual Funds Work?

You have probably heard of them, but how do mutual funds work?

Many people look into mutual funds because they are looking to invest their money for the long term.

A mutual fund is basically a big pool of money that belongs to a  group of investors that is invested on your behalf by a fund manager. Some funds have more than one fund manager. The fund manager has the option to invest in many financial instruments such as stocks, cash, bonds and treasury notes.

Now you know what they are, how do you know if they are right for you? Let’s compare investing in mutual funds to buying stocks yourself.

Some of the big advantages of mutual funds are:

Passive investing Investing in mutual funds is a very passive way to invest. What I mean by this is, there is almost no input required from you. You can just invest and sit back.

Better if you have a relatively small amount to invest   You may be aware that if you have a small amount of money to invest, the commissions you would incur buying individual stocks through a stock broker could be very high in proportion to your account size, making it much harder to show a good return on your money.

Minimum knowledge neededWhilst I would not recommend investing in mutual funds if you have absolutely no knowledge of the how the stock market works and stock investing, I feel it would be reasonable to invest in mutual funds with only a basic understanding of stocks and investing. You are effectively paying the fund manager for his knowledge. This is certainly a lot different than if you were buying individual stocks. A much more in depth understanding would be required for this.

Now let’s move onto some of the disadvantages:

Many fund managers suck    I hope you can forgive me for being blunt and to the point, but the unfortunate truth is that many fund managers are very poor and   consequently earn poor returns for their investors. In depth research into a fund and manager is very important when considering which fund to invest in. Take a look at factors like past performance in relation to the main indices such as the Dow Jones and take a look at the level of experience the fund manager has.

Some are Greedy   Some fund managers, even the poor ones can be greedy. Many funds have an initial fee to join and then a yearly maintenance fee. In many cases fees need to be paid even if you the fund performs poorly and loses money. Investing in a mutual fund through a stock broker can often save some of the fees.

It is also worth mentioning that there are generally three classifications of mutual funds:

Equity funds are funds that only invest in stocks. As they don’t invest in risk-free instruments like government bonds, they can sometimes be riskier.

Fixed-income funds are made up bonds, debentures, and mortgage securities. These funds are typically very low risk. However, as many of these securities can be bought cheaply, investing directly, rather than through a fund may prove a better option as it would save on potentially costly management fees.

Balanced funds are a combination of the two. They invest in both bonds and stocks.

Which Broker for investing in mutual funds?

Zecco is my number 1 recommendation for investing in mutual funds. Read my full review here.

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