The Advantages and Disadvantages of Mutual Funds

If you’re seeking a low-risk, long-term investment that can yield an average return of 12% or more over its lifespan, you might consider mutual funds. In 2023, 68.7 million U.S. households and 116 million individual investors owned mutual funds. These figures comprise more than half of U.S. households, making mutual funds the most popular investment last year based on findings from the Investment Company Institute.

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But what exactly are mutual funds and why do they make such a good investment for the average American?

What Are Mutual Funds?

Mutual funds are investment vehicles that combine stocks, bonds and other investments into one package, managed by a professional manager. Because many people buy into a single mutual fund, costs for individual investors may be less than investing in stocks or bonds on your own.

For people seeking a “set-it-and-forget-it” investment with relatively low risk and returns that have outperformed the S&P 500 over the past 20 years, mutual funds can be a good choice.

Types of Mutual Funds

The type of mutual fund you purchase will depend on your needs, your budget and your expectations. Here’s an overview to help you get started.

Active Funds

Actively managed funds, as their name suggests, are overseen by a portfolio manager who decides which equities to include and buy or sell over time. These funds are designed to outperform benchmarks, such as the Nasdaq or S&P 500 indices. There’s no guarantee your mutual fund will exceed the returns of these benchmarks, but that’s the goal.

Index Funds

Index funds track a specific index, such as the S&P 500 or Nasdaq. As such, they are not designed to outperform the stock market, but can provide greater diversification and liquidity with, ideally, equal returns. These tend to cost less than actively managed funds.

Within these options, you can choose from six different types of mutual funds, including the following:

• Equity funds that focus on stocks

• Bond funds that pay dividends

• Sector funds that focus on stocks in a specific industry

• Balanced funds that include a diversified mix of stocks and bonds

Pros and Cons of Mutual Funds

As with any investment, there is always a risk you will lose money. But mutual funds provide enough diversification that there is less risk. Here are some of the other advantages and disadvantages of mutual funds.

Pros

• Diversification creates lower risk

• Automatically reinvest dividends so your money grows faster

• Low costs

• Active management by professionals can yield higher returns

• May track or outperform stock indexes

Cons

• May have associated management fees

• No guarantee of gains

• May lose some or all of your investment

• Interest and dividends are taxable

Advantages of Mutual Funds

As you can see from the list above, the benefits of mutual funds typically outweigh the disadvantages. Here’s a closer look.

Lower Risk

Mutual funds are diversified into a variety of equities, making them more secure than individual stocks. Of course, the level of risk depends on the type of asset classes in the mutual fund. If you choose mutual funds composed of large-cap stocks, the risk should be fairly low. Small- and medium-cap stocks carry more risk, but may provide higher returns. Money market mutual funds offer even more security, albeit at the expense of lower returns.

Automatically Reinvest Your Dividends

As Dave Ramsey pointed out in a blog post, your savings rate — or how much money you invest each month — affects your wealth accumulation more than the savings vehicle, whether you invest in stocks, bonds, mutual funds or ETFs, for instance. Mutual funds provide the opportunity to automatically reinvest your dividends, which increases your savings rate.

Low Costs

You can find many mutual funds with no minimum investment required, although some need $500 to $3,000 to get started. This is a relatively low cost of entry that makes mutual funds accessible to many people. Plus, you can add to your mutual fund at any time so your money can grow even faster.

Actively Managed Funds May Yield Better Returns Than You Could Get On Your Own

Professional stock brokers and investors spend years learning the craft and still don’t get it right every time. But an active fund managed by a professional is more likely to yield a high return than if you were to manage the portfolio yourself. Plus, most people don’t have the time, knowledge or inclination to manage their own portfolios. An actively managed mutual fund gives you the advantage of hands-on investing without having to do it yourself.

May Outperform the Stock Market

If you are looking for a relatively secure investment that has good odds of outperforming the stock market, consider mutual funds. Historically, mutual funds have delivered competitive returns compared to individual stocks.

Of course, there’s no guarantee that any investment will outperform the S&P 500, which has produced gains of over 10% since its inception. And there’s always a chance you’ll lose money in a mutual fund or that your money won’t grow to keep up with the pace of inflation.

Disadvantages of Mutual Funds

Along with all the advantages of mutual funds, you’ll find a few pitfalls of mutual funds.

May Have Associated Management Fees

Most mutual funds have fees that can reduce your earnings. Some expenses are paid out of the fund assets, which means shareholders are paying them indirectly. Others are paid directly by investors. You’ll find all the fees listed in the fund fee table.

Market Risk

As with any investment that relies on stocks, bonds or other equities, your investment could fall and you could lose money.

Interest and Dividends Are Taxable

Interest and dividends received from mutual funds are taxable, although any capital gains won’t be taxed unless you sell the fund.

Alternatives To Mutual Funds

Of course, if you’re creating a long-term investment strategy, you have options other than mutual funds.

Mutual Funds vs. Stocks

Individual stocks may earn higher returns than mutual funds but, in general, many mutual funds have outperformed the stock market over time. If you want to manage your own portfolio, stocks may be a better choice. If you’d prefer a fund manager to do the work, and don’t mind paying the associated fees, you might prefer mutual funds.

Mutual Funds vs. ETFs

Like mutual funds, exchange-traded funds are collections of securities, typically with something in common. Most ETFs are passively managed and pegged to a particular stock index. ETFs are bought and sold individually on the stock exchange, which means there is typically no minimum investment required. You may even be able to buy fractional shares of ETFs.

Mutual Funds vs. Bonds

Unlike mutual funds, stocks and ETFs, bonds have a fixed rate. This means there is less risk, but your return is also likely to be smaller.

How To Choose the Right Mutual Fund

Choosing the right mutual fund depends on the level of risk you are willing to take, how much money you want to invest, and other factors such as fees. You may also choose a specific mutual fund based on who manages it; for instance, if you work with Charles Schwab or Vanguard, you may want to choose a mutual fund in their family of investments.

Final Take

Mutual funds play a significant role in saving for retirement for many people. Many 401(k) plans include mutual funds as one of the investment options. Mutual funds offer the advantages of diversification, low costs and the benefit of having a funds manager oversee your portfolio.

FAQ

Here are the answers to some of the most frequently asked questions about mutual funds.

• What is the main advantage of mutual funds?

  • Because mutual funds include a wide variety of investment vehicles, including stocks, bonds and other securities, they help create a diversified investment that is less volatile than individual stocks, which also makes them more liquid.

• Are mutual funds a good investment?

  • Mutual funds are a good investment for individuals looking to save for long-term goals, such as retirement. Mutual funds help you diversify your investments for less volatility and more liquidity, without needing extensive experience or knowledge about the markets.

• Are mutual funds high or low risk?

  • Mutual funds tend to be lower risk than many other types of investments because they provide diversification, offering a collection of stocks, bonds and other equities in one fund. There is always a risk of loss with any investment, but most investors don’t consider mutual funds to be a large risk or gamble.

This article originally appeared on GOBankingRates.com: The Advantages and Disadvantages of Mutual Funds