They’re often touted as a steady, low-risk way to invest your money. But a mutual fund investment isn’t always a good idea.
On the surface, a mutual fund investment is a smart move for most investors. When you don’t have the cash to buy shares in major companies, a mutual fund can give you exposure to those well-known stocks. Moreover, a mutual fund investment helps you diversify, so you can lower your overall risk.
Mutual funds are professionally managed by an investment company, with big research departments and plenty of intellectual firepower in their economic forecasting staff. This certainly seems like it would benefit individual investors, especially those who don’t care to take on the research and management of investments themselves. But there’s a catch.
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How a mutual fund investment works (and why that can limit an investor’s success)
If you’re a mutual fund manager, you pick an index to use as a benchmark. This might be the Dow, the S&P 500 or the Nasdaq or an index that tracks a particular market or sector. The Dow is slightly more conservative, the S&P is taken to represent the broad market and the Nasdaq is weighted toward tech stocks, which gives it a little more volatility.
Mutual funds always use an index as a benchmark because they need a way to measure whether they’re doing a good job. So, first step for a mutual fund in beating the index is to essentially buy the index. Large mutual funds usually hold (almost) every stock in their benchmark index, matching both the holdings and the weightings of the whole shooting match.
And then the tweaking begins. Fund managers use their substantial research resources to identify the stocks with the strongest and weakest projected performance and then tweak their holdings. If the index has 1% of a certain stock (by market cap) and the wonks in research believe it’s a winner, the manager might raise his weighting to 1.25%.
Maybe a manager’s research points to a slight decline in desktop computer sales during the next year. So he shaves off a small portion of his exposure (relative to the benchmark) to a parts supplier or a retail outlet that sells desktops.
Overseeing this ballet of micromoves there’s usually a risk manager who keeps tabs on the potential risk generated by each of the moves. If the risk manager believes that the risk exposure has risen beyond what’s authorized by the portfolio guidelines, he blows his whistle and the portfolio manager dials back his (or her) aggressiveness.
That’s pretty much how mutual funds work, with the choice of benchmark dictating the portfolio’s investment universe, aggressiveness and objectives.
The downside of a mutual fund investment
Individuals can make far larger gains with a few smart stock investments. The action of a few stocks can give you a big gain in your portfolio value. Mutual funds, by contrast, hold dozens and dozens of stocks, which keeps a big winner from making more than a small contribution to total performance.
The usual approach used by most 401(k) and IRA investors follows the standard advice. Lots of index funds, wide diversification, never change a thing, and rely on the effects of time and continuing contributions to build value.
For many people, that’s exactly the right answer, because they don’t have the temperament or the expertise to buy individual stocks. The market can be a tough place to learn lessons, and those lessons can be expensive.
If you’re interested in learning how to invest on your own, without limits on your gains, download our FREE report, The Best Investment Sites to Research Stocks.
What else would you like to know about mutual fund investing? Let us know in the comments below.
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