Mutual Funds for Beginners

For the beginning investor, the notion of hand-picking your first six to 10 stocks can be a bit overwhelming. Selecting a mutual fund can serve as a convenient, cost-effective entry point into the world of investing that can be less risky than picking individual stocks.

Fundamentals
A mutual fund is simply a collection of stocks, bonds, short-term money market instruments, other securities, or any combination of such assets. Investors buy shares in the fund, and a manager makes the decision to buy and sell the securities that make up the fund's portfolio. This is considered active management, and there are fees associated with each fund to pay for that.

There are all sorts of mutual funds to pick from these days, and they can hold a wide variety of investments. The list below outlines a few of the most common funds available:

Fund Type

Description

Bond Composed of bonds. Called a "fixed-income" investment because these funds typically collect a set amount of interest.
General Equity (stock) Composed of stocks. Funds are frequently limited to all large-, mid-, or small-cap equities. These fund types are often structured as "value," "growth," or "blend" funds.
Balanced Mix of stocks and bonds.
Global/International Targets foreign companies, though global funds may include some from the U.S. as well. Typically more volatile than domestic funds.
Sector Targets companies in a specific sector of the economy, e.g., technology, energy, consumer goods, etc. Can be quite volatile.
Index Matches the shareholdings of an index, like the S&P 500 or the Dow Jones Industrial Average.

The biggest fund out there today is the bond-focused Pimco Total Return (PTTAX). That fund holds $244 billion in assets -- that's larger than the annual GDP of Finland.

Fees
Fees are all over the place and cover a variety of expenses associated with running a fund. Every fund lists its fees in the prospectus, and while it may seem a bit confusing at first, definitions for the variety of fees can be found in our handy mutual fund glossary. The most important definition for our purposes today is expense ratio. This is the percentage of total assets that is used to pay for fund expenses.

Fees vary from fund to fund, and they can have a significant effect on your returns. Let's compare two funds that return 10% annually on an initial investment of $10,000. Assuming we hold the money in our fund for 20 years, a fund with an expense ratio of 1.5% will reach $49,725. A fund with an expense ratio of 0.5%, however, will finish with $60,858 after the two decades are up.

FINRA has a useful fund analyzer that can help you compare the fees and expenses for a variety of mutual funds before you make your final decision.

Fund pros and cons
Frankly speaking, 80% of mutual funds do not beat the market. The higher the fees, the better the fund must perform in order to generate a meaningful return. And most of them never quite make it.

However, if there was no upside to mutual funds, we wouldn't bother dedicating an entire series to the topic. Advantages to mutual fund investing, if you find the right one, include:

  • Exposure -- The best funds offer instant diversification, exposing your portfolio to a variety of sectors, industries, and companies.
  • Volatility -- Bad news for one company won't sink your entire fund.
  • Access -- Funds give you the ability to cash in on securities you may never have dreamed of buying individually, increasing the diversity of your portfolio even further.
  • Cost -- You do not need to pay a commission every time you buy shares of a fund. Though a lot of funds sport an expense ratio of 1.5%, there are some bargains out there.

Mutual funds can be a great investment vehicle, if you take the time to separate the wheat from the chaff.

Mutual appreciation society
Though many funds are duds, there are also some great investments out there -- and you can find them. Research is essential, and there are no shortcuts around that. It's important to keep in mind that old investing cliche, because just like stocks, a fund's past performance is no guarantee of future success.

As you begin your research, there are many things to consider when comparing and eventually selecting the right fund. For starters:

  • Fund fees.
  • Volatility.
  • Tax efficiency.
  • Manager tenure/turnover.
  • Fund strategy.
  • Consistency with your investment goals.

That last bullet may be more important than you think. Though funds offer investors exposure to securities they might not have picked on their own, there is no excuse for not knowing what those securities actually are and how they align with your investing philosophy.

For instance, some investors believe that oil prices are poised to decline further and therefore don't want to own ExxonMobil (NYSE: XOM  ) or Chevron (NYSE: CVX  ) . Yet these two stocks are often among the top holdings within portfolios of large-cap mutual funds. Similarly, if you avoid Altria (NYSE: MO  ) , Las Vegas Sands (NYSE: LVS  ) , and other "sin stocks" on personal grounds, you'll have a tough time with many mutual funds, as a big percentage of both stocks and many others are held by mutual funds and other institutional investors. If you've never looked at your fund's holdings, you may own them and never know it.

It may sound like a lot of work in the beginning (it is), but the research you put in initially can provide peace of mind in the long run.

Foolish takeaway
Knowing that 80% of mutual funds don't beat the market can turn off many investors. The sheer number of funds can be overwhelming, but the availability of information on the Internet makes diving in a little bit easier these days. With resources from companies such as Morningstar, you can get excellent mutual fund data and analysis and is a great place to start your research. For another fund idea, click here to check out The Motley Fool's retirement-focused special free report.

Fool contributor Aimee Duffy doesn't own shares of the companies mentioned in this article. Check out what she's keeping an eye on by following her on Twitter, where she goes by @TMFDuffy.

 Motley Fool newsletter services have recommended buying shares of Morningstar and Chevron. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (9) | Recommend This Article (49)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 21, 2012, at 11:31 AM, cp757 wrote:

    People buy mutual funds and ETF because they don't want to be involved in the stock market. Can you blame an investor for wanting some one else to mess with the manipulation ? The investor is told over and over don't buy and hold because you will lose money but that is just another game they are playing. If you bought a Mutual Fund on 03/09/2009 at the bottom of the crash, as you say 80% of the Mutual funds would under perform. If you picked that "Sin Stock" LVS you would have a 3,200% increase even at today's price.The other thing investors need to know is LVS is diversified and not the 'Sin Stock" it once was. The "Integrated Resort" is what has taken over for the old style addiction model with good gambling stocks. Convention centers, Restaurants, and entertainment venues at the Integrated Resorts in Vegas, Macau, Singapore, and Bethlehem Pennsylvania are what the industry has gone to. The Sands Bethlehem in Pennsylvania had a 69% increase over last year in table games. That was a record 201.5 million dollars in 3 months. Slots have always been good for them and they did 1.03 billion dollars in 3 months and that was a 17.3% increase. The adjusted property EBITDA for 3 months increased 24.4% to a record 27.5 million dollars. In 2011 Las Vegas Sands opened 13 new retail stores at Sands Bethlehem and they just opened a 50,000 SF Events Center that will bring in millions more. Over the next few months they will open 18 more stores. They are the number one casino on the east coast in terms of profit in a very competitive market. Las Vegas Sands had a record adjusted property EBITDA of 1.07 billion dollars in 3 months. That was a 43% increase over last year. Las Vegas Sands is firing on all cylinders and taking market share from the company's around the world. They are the number one Casino in Singapore and they are taking market share in Macau with the new Cotai Central and they are taking Market share in Vegas from all the competition. Mutual Funds are not the best way to go. Just buy company's like Las Vegas Sands and Apple and you will do just fine. They both pay dividends and they will grow revenue more than any company's I can think of with safety.

  • Report this Comment On May 22, 2012, at 11:11 PM, petrogold wrote:

    I tried with other stocks & retained until record dates to get the dividend declared. Then I sold the stocks to buy another with record dates. I did receive some dividend, but not from all. Would receive the dividend at all?

    Now I read a book from Warren Buffet's professor Ben Graham “Security Analysis" -Pub.1934, and found that to buy underpriced stocks with dividend yields, I purchased some mutual funds with same conditions. Have I done the right thing or not? Should I hold as an investment? Will I receive dividend yields as record date is past? If any Fool's advice could be found, would be appreciated.

  • Report this Comment On May 24, 2012, at 5:21 PM, nicolasisaza wrote:

    I have made a total of 25% in the last quarter and a half, mutual funds stink considering the fact that I am thirteen years old..

  • Report this Comment On May 25, 2012, at 2:35 PM, sidehiller wrote:

    I don't think it's necessarily a problem if a mutual fund holds a cyclical stock (for instance, an oil stock) that is "poised to decline"--IF the mutual fund's basis (per-share cost of their position) is comfortably below the current "doomed" high price of the stock.

    One of my issues with prospectus documents is, the information on mutual fund's equity holdings is not only dated ("yesterday's news"), it never shows what the per-share basis of a stock position is.

    So when you read in a prospectus that a mutual fund has X% of its total holdings in a certain stock, it may not be true because the fund manager may have traded out of the stock by the time you read the prospectus. And without knowing how far ahead (or behind) the mutual fund is on that position, the information isn't all that useful in knowing whether the mutual fund managers are clever or not.

  • Report this Comment On May 26, 2012, at 4:40 PM, culcha wrote:

    I think the most important things that any beginning investor should know about mutual funds are (1) never pay a load, (2) keep the expenses as low as possible, and (3) since the majority of mutual funds underperform their index, consider investing in index funds -- which not only have low expenses, but can be bought directly from large mutual fund families (such as Vanguard or Fidelity) with no commission.

    If an investor is serious about avoiding "sin stocks," and wishes to invest in mutual funds, there are mutual funds that avoid such stocks and practice "Socially Responsible Investing."

  • Report this Comment On May 31, 2012, at 12:23 AM, yiki wrote:

    The argument was made by the author of the pie e above!!,that is invest in index funds!!!! Since they will beat over 80% of actively managed funds, and at a much lower cost to boot!!!!! Don't let anyone tell you otherwise. Be a true fool !!!

  • Report this Comment On May 31, 2012, at 11:46 AM, jiminma77 wrote:

    Funny how they tell you to find a fund that has a low expense ratio, when the Fool mutural fund charges 1.58%

  • Report this Comment On June 04, 2012, at 9:29 AM, StopPrintinMoney wrote:

    stick with Vanguard Index ETF's

  • Report this Comment On July 31, 2013, at 5:58 PM, thatguy101 wrote:

    I invested $50,000 in a sustainable fund and my monthly returns are approx. $3,220.00 a month. some months are more some are less.if I had more bulk down investment say double that to 100,000.00 I would get about $6440 a month. and this is my first time ever investing. such a great deal

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