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Are Mutual Funds For You? |
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Written by Value Seeker
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Friday, 04 January 2008 |
Mutual funds and index funds can be an incredibly efficient investment vehicle for many types of investors. Depending on the type of investor you are, a mutual fund or an index fund is an attractive option.
First, let's define the difference between a mutual fund and an index fund. Both are investment options that allow an investment house to manage your money for you. Both are bought and sold in the same way. The only difference is how the funds are managed. A mutual fund is an actively managed fund, meaning the mutual fund manager actively buys/sells stocks he believes will perform well.
Mutual funds generally focus on a certain stock sector. For example, a small cap mutual fund will have the bulk of its assets in small cap stocks. But the small cap stocks the fund manager chooses are ones he believes will perform best. In contrast, an index fund is a passively managed fund. These funds just put their money in the companies that are composed of an index. The most popular index funds generally track the S&P 500. These funds just buy the stocks that are part of the S&P 500.
The advantage of your standard, actively managed mutual funds is obvious. The fund manager chooses the best stocks (in his opinion), not just stocks that happen to be composed of an index. However, actively managed funds generally underperform index funds. This is mainly because of fees. Actively managed funds charge much higher fees than passively managed funds, and they also incur more trading expenses, which they pass on to you, the customer. They are also more tax inefficient due to their constant buying and selling of securities.
The first decision to make regarding index funds and mutual funds is whether or not you are interested in someone else managing your investment money for you. Here are common reasons people buy either mutual funds or index funds:
1. Time: Most people do not have adequate time to dedicate to researching individual stocks. These people are honest enough with themselves to know that they have a major disadvantage against investment professionals, since the pros spend their entire day researching the market. People may also not want to deal with having to research stocks and would rather use their time to pursue a leisurely activity.
2. Small Asset Base: If you have a small asset base, commissions and fees related to trading will eat you alive if you trade much. The fees incurred by investing a mutual fund are often a lot less than the fees charged buy a broker to buy/sell stocks in relation to your asset base.
3. Lack of Knowledge: Stock investing isn't easy! It's difficult to even match the market, no less beat it. Why bother trying when you can just invest in a mutual fund or an index fund?
4. Diversification: It's much easier to achieve diversification through funds than individual stocks.
If you decide mutual funds and index funds are for you, how do you decide between the mutual funds and the index funds? Some say that since most mutual funds underperform the market, you should just go with index funds. But, some mutual funds do outperform index funds, so if you can identify those, you are better off with mutual funds.
Only you can make the decision whether you are better served by a mutual fund or an index fund. If you think you can identify a winning mutual fund, then go ahead and try investing in that. If the whole fund world confuses you or you don't want to deal with identifying a good mutual fund, you are better served by an index fund. This site has many articles related to mutual fund investing, so those are a good start for those that are considering mutual funds.
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