Tuesday, January 3, 2012

How to Deal with Mutual Funds - The Good the Bad and the Ugly

Mutual Funds have been around for many years. They have developed and adapted to the changing times.But are they really something you should invest your hard earned money into ?

What mutual funds do is pool the money of many investors and purchase investments with this money. They could invest in stocks, bonds, Real Estate Investment Trusts, or many other forms of derivative securities. The individual investor has no control over what is purchased and what is sold. ( or when it is purchased and sold)
The fund hires a manager to do all of this for the investors.

These managers operate within guidelines that are set out when the fund is originally set up and must follow the rules. Mutual Funds are sold by a legal document called a Prospectus which every investor must read and understand before investing.

                                                                          The Good

Mutual Funds started out many years ago as a way for the small investor to gain a better rate of return than leaving their money in their bank accounts. A small investor, otherwise, would not have been able to afford the fees of professional management.

Mutual Funds have many good features such as, instant diversification of investments with a single small investment, professional management, liquidity (you can sell your shares at any time), reinvestment of income, etc. You can also arrange to invest a specific amount each month to add to your investment.

They are still a good vehicle for someone starting out. Also, for anyone having trouble saving, funds are harder to get at and can not be accessed from your bank card.

                                                                        The Bad

The annual fees that Mutual Funds charge can be up to 2.5% of the value of your investment. What this means is that you will automatically be making up to 2.5% less each year than the investor who invests directly  in the underlying securities. This amount is called the MER (Management Expense Ratio) and can be found in the fund's prospectus. Check this amount before investing.

Managers of funds always get paid, even if the fund loses money. In bad years this will add up to 2.5% to the loss of your investment if you should sell. The key here is not to sell when your funds are down (as with all other investments, normally) You must trust that the manager will make more gains for you in the future.

                                                                        The Ugly


Many investors in Mutual Funds have no idea what their money is invested in. They do not understand that most Mutual Funds change in value on a daily basis. They rise in value and fall in value, quite often below the amount of the original investment.

When prices fall too far some Mutual Fund investors panic and sell their shares. Too much panic can force managers to sell good investments when they are at a low point, therefore causing all investors to lose money.

The biggest drawback to Mutual Funds is the lack of understanding on the part of most Mutual Fund investors. They simply don't understand the risks of investing and can pull everyone else down with them.

                                                                      Choices

The Mutual Funds I talked about above are termed open mutual funds which are sold through most banks and financial advisers. You buy and sell your units through the mutual fund company itself and receive the cash directly.

Another form of Mutual Funds are the closed Mutual Funds. These are listed on the various stock exchanges and you buy and sell their units on the open market to individual investors. Closed Mutual Funds eliminate the risk of the Ugly part above but still have the costs associated as in the Bad part above.

Mutual Funds whether they be open or closed still have a place in most investors' portfolios. The important thing to remember is their inherent advantages and disadvantages over purchasing individual investments.

When investing, the more control you  have will usually mean the less diversification you will have. As in most things, having a balance of both mutual funds and individual securities is usually the best choice. However, that is completely up to the individual investor to decide.

As always I welcome your comments and suggestions for future topics.

                                                               

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