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Investing in a Mutual Fund

Mutual Funds

Even in the wake of the Great Recession, the mutual fund has proven itself a worthy investment for the average person. In fact, many people are actually looking towards mutual funds as their hedged bet into the world of variable investments.

In order to fully understand how to invest in a mutual fund, you must first understand exactly what a mutual fund is.

What Is A Mutual Fund?

A mutual fund is a basket of investments that is chosen by a management team for the profitability of the investors. This is why many financial investors actually say that when you are investing in a mutual fund, you are investing in the reputation of the managers as well as the reputation of the underlying businesses.

Mutual funds usually have some kind of theme that combines the investments in the basket. For instance, all of the investments may be related to the precious metals market. In this case, the title of the mutual fund would be something like “Bank X Precious Metals Growth Fund.” Although the title of the mutual fund can give insight as to the underlying investments, they may only represent the top percentage of holdings. We recommend that you check into the actual underlying investments that are currently being held in the mutual fund to be sure that it is actually investing in what you think it is.

How Mutual Funds Work

Investing in a Mutual FundThe main idea behind a mutual fund is to allow an investor to  instantly diversify their investments with a single purchase. The managers will spread out the total money collected from the investors into companies that are related to the theme of the mutual fund. Because of this, mutual funds are usually thought of as a relatively safe investment that is made for those of a lower risk tolerance. However, the rewards that accompany a mutual fund are usually not comparable to those of individual securities and short-term. They may be in the long-term depending on many variables.

Mutual funds have a scale of risk that is associated with a general view of the mutual fund market. If a mutual fund is marked as a “growth fund,” this means that investors should invest in this fund with the hopes of growing their investments over a certain time period. However, there is more risk and market volatility associated with a growth fund than with  some other types of funds.

 

Investing in an Index Mutual Fund

Those who are looking for a safer investment may want to invest in something known as an “index fund.” These are usually mutual funds that include a basket of investments that follow the performance of an entire index. Because an index is one of the most diversified investments that is possible, encompassing every company on the index, any mutual fund that follows the performance of an index will most likely be relatively conservative. However, a lot depends on which index you choose. You can choose a broad index comprised of large stocks like the NYSE or an index comprised of faster growing stocks like the NASDAQ or even an index of Gold Mining Stocks or even a Bond index. Generally, because mimicking an index doesn’t require the same level of management the fees associated with an index fund are lower.

3 Tips For The Average Investor Investing In Mutual Funds

There are many different types of mutual funds available based on risk tolerance and industry preference. Below are some of the tried and true methods of narrowing down the mutual funds that you should consider as an average investor.

1. Do you understand the industry that the mutual fund is associated with?

Although a mutual fund is diversified across a variety of companies if it is focused on one industry it is still highly risky. For instance, if you invest in a mutual fund that invests strictly in the airline industry it will probably hold shares of American, Delta, U.S Air, etc. it may even hold shares of Air France, and Lufthansa and Cathay Pacific this will help protect you from a specific airline going bankrupt but if the price of oil goes up all the Airlines expenses will rise and the industry as a whole may perform poorly. So although you won’t be exposes to as much risk from choosing a bad company you might still choose a bad industry. Financial experts advise that investors know about specific industry risks before investing in an industry specific mutual fund because the mutual fund still contains market risk, there is still a definite possibility of principal loss no matter how diversified the mutual fund is. The savvy investor counteracts this risk with knowledge of the industry or by sticking to mutual funds diversified over a variety of industries.

2. How well has this fund performed in the past?

Although past performance is no guarantee of future performance… a good track record is preferable to a bad track record (or no track record). Try to channel your investment money into the funds with with a long, strong track record.  This doesn’t mean to choose the best performing fund of last year. Typically, the best performing fund of last year might not do so well this year. Look at longer term performance as well. Also compare the performance of the fund to that of a comparable index or industry. Has the fund outperformed the industry or underperformed the industry. You are paying managers to choose the best stocks… if they can’t outperform the industy average find a fund that can.

3. What is the caliber of the management team?

Many investors are surprised to find out that the average age of the mutual fund manager is in the high 20s. This is much younger than the age of the average mutual fund investor. Since you will most likely have someone younger than you handling your investment income, it would behoove you to research them thoroughly. There are many mutual fund managers with years of experience and a good track record. Before buying a mutual fund be sure to check out the management team. Also beware of new management. If you’ve checked out the funds performance as suggested in #2 but the management team has changed the whole philosophy of management for the fund can change and so in this case past performance will have almost nothing to do with future performance.

Investing in a mutual fund can be a good way to spread the risk and deligate the job of managing your money. But you are still responsible for your choices. Choose wisely and you will do much better than the average investor.

Photo credit: Wonderwebby via Flicker Creative Commons

This is a guest post by Chris Keenan,  who writes on a variety of family and finance topics.

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