Mutual Funds: Ignore Them at Your Peril

You may think your nest egg is in good hands, distributed among your savings account, some CDs, and perhaps some stocks, too. But such an arrangement isn't best for many people and will not deliver the retirement they hope for. One great way to improve your financial future is via mutual funds -- as long as you're smart about it.

First, though, understand why savings accounts, CDs, and stocks aren't always great for your long-term money. The current low-interest rate environment is one factor, leading bank accounts, CDs, and bonds to generally offer anemic growth. With the average inflation rate typically around 3%, these investments are often shrinking your purchasing power over time. Yikes! Stocks can be a much better choice, but not if you haven't taken the time to learn about stock investing and how to do it well. Thus, mutual funds can be the best long-term route to financial security.

Here are some key advantages -- and dangers -- of mutual funds:

The upside
For starters, funds let you hire financial professionals to manage your money. You probably have a job that takes up much of your day, along with your family and other responsibilities. It can be hard to find time to focus on finding great investments. Thus, it makes a lot of sense to let some smart folks you trust manage your money for you.

These folks' talents can be had relatively inexpensively, too. For managed mutual funds, you might pay 1% of your assets or a bit more each year. It's not insignificant, but if your money is growing well over time, it can be well worth it. There are plenty of very inexpensive mutual funds out there, too, such as index funds. Index funds often charge 0.25% or less, because they simply track (i.e., copy) an existing index, such as the S&P 500. They don't require the brilliant thinking of professionals.

Then there's diversification. Most of us know that it's important to spread our eggs over a range of different baskets, lest one disaster wipe us out. But that's easier said than done, especially when you don't have gobs of dollars or hours and hours to research and select a good assortment of holdings. Many mutual funds, though, such as ones based on a broad-market index, offer instant diversification. Park your money in an S&P 500 index fund, for example, such as the Vanguard 500 Index (VFINX), and you'll immediately have your money spread out over several hundred diverse companies, ranging from computer makers to food companies to utilities and more.

The downside
As with most things, there are a few downsides to mutual funds. They can mostly be avoided, though. Here's the worst one: Most managed stock mutual funds underperform the market! That's right. You'd think that the very educated and well-dressed financial pros who manage mutual funds would be turning in impressive performances, but over most long (and many short) periods, most of them don't do as well as a simple index fund. In most cases, you'd be better off just choosing the index fund.

One reason many underperform is that they're just not as talented as they seem, or they're employing wrong-headed strategies, such as jumping in and out of many holdings frequently, instead of patiently waiting for long-term rewards. But a key reason for their underperformance is their fees. If a managed fund is charging 1.25% per year (and many charge more) and an index fund is charging 0.25% (and many charge less), then that will make a big difference over time.

Some mutual funds are just dangerous, too, and should only be considered, if at all, by those who know what they're doing. Among exchange-traded funds, which are cousins of traditional mutual funds, for example, you'll find some ultra-leveraged funds, which can amplify gains and losses and can be disastrous when misused.

The last real danger in mutual funds is the investor himself or herself. If you're wowed by a fund's amazing past year, for example, and park much of your money into it, you may be surprised when it doesn't have another amazing year. That's just not how it usually works. You might, alternatively, load up on lots of small-cap funds, failing to diversify well with large companies. Or you might omit international stocks, which is also not best -- though many big American companies these days do generate much of their income abroad, so you can actually include an international element in your portfolio that way.

The bottom line
Mutual funds are simply one of the best options for many of us, especially if we don't have the time, the skills, or the interest to study stocks and make lots of investment decisions on our own. And among mutual funds, while there are indeed plenty of great managed mutual funds with a decent chance of outperforming the overall market, broad-market index funds are the best bet for many people. They're among the cheapest options, and offer solid long-term performance.

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