Investing in Mutual Funds sounds a little scary, doesn’t it? I would venture to say that whenever the topic of investing in general comes up, many people roll their eyes and get up to get another drink, right? Well, in this review of Investing in Mutual Funds, I will attempt to make mutual funds a little easier to understand and perhaps give a different perspective.
Investing in Mutual funds doesn’t have to be challenging. There are three main things to consider before investing in mutual funds, first, is how do I start investing in mutual funds, second what factors to consider when investing in mutual funds, and lastly, which one or ones should you buy.
How do I Start Investing in Mutual Funds?
Investing in mutual funds can be very easy. In my opinion, the best way is to open an account, either a brokerage account or IRA is at a bank for financial institution. The account is simply the vehicle that allows you to purchase the various funds. A Brokerage account has different tax implications than an IRA, but can be opened oftentimes with zero dollars. The brokerage account can act somewhat like a bank account, where you can buy stocks, bonds, mutual funds, etc. Once the account is opened, work with your financial advisor and pick what fund you would like to purchase. It’s that easy. I created a quick guide below for investing.
Quick Guide to Investing in Mutual Funds
There are many factors to consider which mutual fund to buy. I would strongly suggest that you consult a financial advisor if you are considering investing in a mutual fund. Some of the key factors to consider when investing in a mutual fund are: Risk profile, fees, taxes, ratings and investment portfolio.
Is Investing in Mutual Funds safe?
Investopedia defines Investment risk as the potential of an investment to lose value over time. With mutual funds, diversification can mitigate this risk, but it does not eliminate it. There are five categories of investment risk; Aggressive, moderately aggressive, moderate, moderately conservative and conservative. You can find several calculators on the web which can help you establish a risk profile. Here is one that I found helpful: Investor Profile Questionnaire.
Investment Fees
Fee are thought of as a dirty word in many circles. Although, if you understand the fees, you can learn what to avoid. There are quite a few low-cost mutual funds out there. Some of the obvious fees to consider are the brokerage fee and the purchasing fee. The brokerage fee is simply what the financial institution charges you to buy the mutual fund. This can also be called a commission. The purchasing fee or load is the fee the mutual fund company charges to buy into this fund. I would try to avoid any mutual funds that charge an upfront fee. Both commission and load fee. There are many funds in all categories that do not charge upfront fees.
Other fees that you may see are 12B-1 fees, short term redemption fees, contingent redemption fee and expense ratio. Keep in mind the mutual fund companies want to make a profit. This is one of the pillars of having a business, however every fee that you see on the mutual fund affects your future growth potential. Think of it this way, if you invest 100 dollars and your total fees are 5 percent, then you really only invest 95 dollars. Similarly, if you invest at a 2 percent total fee cost, then you save 3 percent.
Now consider that over 30 years with a 100 dollar investment per month at an average annual rate of return of 8 percent. At the 5 percent fee level, after 30 years you would have roughly $59,000 dollars. Conversely at the 2 percent fee level you would have over $101,000 dollars. That difference of 3 percent (from the 5 to 2) cost you over $42,000 more dollars.
Investing in Mutual funds and Taxes
This section goes somewhat without saying, if you make money on your investment, you could be taxed at a certain level. This will depend on whether or not you open a brokerage account or a retirement account. Also, it will depend on how long you keep the investment. I would encourage reaching out to a tax advisor for any specific questions in this section.
Investment Ratings
Morningstar is probably the most well known rating agency for mutual funds. They will give a star rating on a mutual fund from 1 to 5 stars and this is purely their opinion on the performance of the fund. Something you need to know is that, past investment gains do not predict the future of the investment. Even if a mutual fund is rated at 5 stars, this does not mean it will perform this well forever.
Most brokerage companies also have internal ratings of mutual funds and offer them as options which the company would recommend. An example of this is a “select list” or “fund picks list”. These are not necessarily official ratings, but suggested funds from the brokerage company.
Investment Portfolio
The investment portfolio is definitely something to consider when investing in mutual funds. In the portfolio section there should be a breakdown of what the mutual fund invests in. You should see four categories at least; equity, bond, cash and other. Equity simply refers to what company stocks this mutual fund buys. Likewise bonds are also something a mutual fund can buy. The amount of cash sitting in a mutual fund is designed to be available for quick investment. It is also used as a small hedge to protect against the investment going down.
The other section typically refers to alternative investments. You may have read in Mutual Funds: What are They? that a mutual fund can invest in real estate and commodities. These are part of the “other” section. They can also be referred to as alternative investments.
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In Which Mutual Fund Should You Invest?
Unfortunately, I do not have a crystal ball and I cannot tell you exactly what to invest in. As with every investment, it will take time and research on your part. However, what I can tell you is this; if you factor the risk, fees, taxes, ratings and portfolio, you can make an educated decision. If you literally have no idea how to start, think of things around you. Invest in things that you like to know about. Invest in companies that you like to use.
One of the Templeton rules for investment is, “Diversify. In stocks and bonds, as there is safety in numbers.” Consequently, if you consider all the mutual funds that are out there and use the quick guide from above, any financial institution is able to help you. I personally know that Charles Schwab has a mutual fund screener program that can help you narrow down your choices based upon various criteria. Make sure to ask about portfolio diversification and Index funds.
If after reading this, you are still unsure how to start, please read one of these three books; ‘The Little Book of Common Sense Investing‘ or ‘The Templeton Plan‘ or ‘The Path‘. These three books have great insight on mutual fund investing and financial planning in general. Remember though, reading is great research, but make sure to take action and not just build knowledge. Knowledge is simply the potential for power.
I hope you enjoyed this post on investing in mutual funds and it offered some additional advice in the crazy world of finance.
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