A lot of people are often confused about the differences between a stock and a mutual fund. The two terms are often used interchangeably despite the fact that they are two completely distinct investments. Both asset classes can provide investors with growth but their are different risks and rewards for each.
What are mutual funds?
A mutual fund can easily be described as a collection of different investment assets. A mutual fund can invest in stocks, bonds, commodities, and money markets. Mutual funds allow investors to pool their money together to purchase securities. This increases the buying power of the group and can also provide diversification if structured properly. While most mutual funds do invest in common stocks, there are a large number of funds that do not. For example, bond funds and money market funds expressly invest in those assets.
Learn about the Different Types Of Mutual Funds
What are the advantages of mutual funds?
The primary advantage of a mutual fund is that you get professional management. Mutual fund companies hire investment management teams whose job it is to keep track of the fund assets. Fund managers are responsible for buying and selling assets. A good fund manager can provide performance that exceeds the market’s total return. Bill Miller at Legg Mason is a good example of this. His Value Trust fund outperformed the S&P 500 for 15 consecutive years.
Mutual funds reduce the need for investors to keep up with their investment assets on a daily basis. An investor in a common stock needs to be concerned with the performance of every single company in their portfolio. This requires time and consistent research. Mutual fund investing does not require day to day research. Most mutual fund investors only have to watch their portfolio on an annual basis.
Lower Transaction Costs
Since mutual fund managers buy larger amounts of securities than ordinary investors, the have lower trading fees as well. This can save an investor money if they buy a fund in which assets are held for at least a year.
What are the disadvantages of mutual funds?
A poor fund manager can destroy the performance of an investor. A bad fund manager can force an investor to miss out on the upswings of a bull market and exacerbate the poor returns of a bear market.
Mutual fund fees can vary heavily from fund to fund. Some funds have fees that are lower than 1%, while others have fees that are as high as 6%. These buying and selling sales charges can rob an investor of long term growth. That is why it is so important to pick the right mutual fund.
A fund that is actively traded can force an investor to pay taxes even if the fund lost money for the year. Active trading is a losing proposition for a mutual fund investor who buys these funds for their long term performance.
Mutual fund investors can either buy shares through the fund itself or through a broker. Investors will pay a price known as the Net Asset Value (NAV). This is similar to the market price for a stock. Mutual funds are only priced once a day after the market closes. Redemption requests can be made at any time and are redeemed by the fund company.