7 Things You Need To Know About Mutual Funds

One of the best ways to build wealth over time is through investment in the stock market. However, these investments can be dangerous for many people for one major reason. Investing in the wrong stock can cause you to lose your entire investment. If a company goes bankrupt, its stock’s price is likely to go to zero or some low number that’s close to it. When people lose money like this, it causes others to have some major concerns about the market as a whole.

This is where mutual funds can come in handy. Funds are effectively a basket of stocks. They hold many different companies within them, which provides for instant diversification for regular investors. Rather than losing your whole investment if a company goes bankrupt, you will likely lose less than 5 percent of your investment, most likely a great deal less, if you hold your investment in a mutual fund.

Most funds will hold tens, if not hundreds, of companies within them. It is likely that a company or two will go belly-up over time, but it is highly unlikely that they will all lose all of their value at one time. This is one of the major benefits of using mutual funds as investment vehicles. Here are some other areas to consider when putting your finances toward mutual funds.

1. Know Management Tenure

Each fund will have a manager or a group of managers who are given the task of selecting the appropriate investments for a given mutual fund. Some funds will have a lucky year and show market-beating returns. They might also have a new management team. It’s a good idea to look into how long the manager of your prospective fund has been in his or her position. Those with long track records of success should be more attractive to you as an investor than someone who has only been working with a given fund for a year or two.

It’s possible that a given manager will move from one fund to another. Therefore, you’ll want to look at this person’s entire body of work. With search engines like Google and Yahoo!, this process has never been easier. Just type in the individual’s name and click search, and any wide variety of articles and pages will come up to show you how long a manager has been in business and how successful they’ve been. Be sure to search for quality in this regard, or your returns might lag behind those of the market as a whole.

2. Check the Annual Expenses

Every fund will have a management fee associated with it. This expense ratio gets charged to the individual investor on an annual basis, and it cuts into the overall return that you can expect to see from your money. It’s important to remember that the annual fee as a percentage will compound over time. Also, the higher your balance, the more you’ll pay. Paying a little bit for quality is a good idea if your fund manager routinely beats the market. Just remember to subtract the annual fees from the track record to see if the fund really has beaten the index that’s correlated with the fund’s investment thesis.

3. Ask About Short Term Trading Fees

Sometimes, life will throw you a curve. An unexpected medical expense or a job loss might leave you in need of funds quickly to survive the storm. Some funds will have short-term trading fees that will add insult to injury in such a situation. In some instances, they may be quite prohibitive. Additionally, you may want your money to go into different investments if your chosen fund does not live up to your expectations or if the market appears to be starting a precipitous decline that you’d like to avoid with cash. Short-term trading fees can hurt your overall returns in these instances and hurt your finances.

4. Don’t Make Assumptions

Do not make assumptions when it comes to mutual funds. Past performance is not a clear indicator of future returns. Just because a fund has done well over the past five years, does not mean that it will see similar returns over the next five. Assuming management will stay the same and that your fund will maintain the same mix of stocks may not be a good idea. Keep asking questions and reading annual reports and prospectus filings so that you’re as informed as you possibly can be when using mutual funds to invest. The only expectation you should have is the unexpected, however.

5. Fund Performance Instabilities

Funds will only mimic the returns of the underlying securities that they invest in. Therefore, an index fund that tracks the S&P 500 will come close to following the returns of the index. If it goes up 20 percent in one year, it may go down 8 percent the next year. Over time, the market tends to give pretty good returns to long-term investors. In any given year, however, the market could go down 50 percent. Before you put your finances toward mutual funds, make sure that you’re fine with watching this instability and volatility. Those who stick with an investment over time will generally do better than those who trade in and out of positions.

6. Fund Diversification

Be sure to look into fund diversification when you go to invest. Generally speaking, the more positions a given fund holds, the better. This will mean that any given investment going bad will tend to have a relatively minimal impact on the overall value or return of the entire fund. Some funds will follow certain segments of the economy. They might follow energy or real estate. These might be more volatile because of the concentration in a given sector that may experience a cyclical downturn. A fund that’s more widely diversified will have sectors that pick up the slack if one is down.

7. Yield Has a Cost

When investing in mutual funds, it is important to remember that yield comes with a cost. Whether it’s a stock with a 10-percent yield or a bond that’s paying 8 percent in interest when the underlying rate from the Federal Reserve is much lower, there’s generally a reason. The market thinks that the high yielder will likely head lower in the case of a stock fund. Bond funds that pay high interest are generally focused on what investors call junk bonds. The yield is usually higher because the risk is higher. The reward might be higher, but investors in these funds should beware if they do not have a relatively high tolerance for risk.

Mutual funds are great for instant diversification. They can also pay off in the long run as the underlying securities pay dividends and experience capital gains. They are great vehicles, but they do come with risk, so it’s a good idea to take these seven concerns into consideration before actually making an investment.