There are three primary reasons why many people choose to own shares of mutual funds (or investment companies, as they are sometimes called), rather than the securities of individual companies.

1. One reason why people own shares of mutual funds is to benefit from professional management.  Because of their education, training, and investing experience, professional money managers are expected to make better investment decisions than novice investors. People believe that having their money invested by professionals will result in higher returns than if they invest their money themselves.

Frequently, however, professional investors achieve mediocre performance – or worse.  For example, one study disclosed that during the 36-year period through the end of 1997, diversified U.S. stock funds had an average annual return of 10.2% before sales commissions and taxes, whereas the return of the Standard & Poor’s 500-stock index (the S&P 500) averaged 11.6%.  In other words, the mutual funds managed by professionals underperformed the unmanaged index of 500 stocks by an average of 1.4 percentage points annually during the 36-year period.  And, an article in The Wall Street Journal indicated that a startling 91% of actively managed stock funds did not perform as well as the S&P 500 during the 10-year period through the end of 1998.

Furthermore, according to another article in The Wall Street Journal (9-12-02),

Almost all fund statistics suffer from what’s called survivorship bias. Fund companies regularly kill off rotten stock funds, typically merging them into other funds with better records. That means these rotten performers disappear from the fund averages, thus making actively managed funds look like a better bet than they really are.

2. A second reason why people own shares of mutual funds is to save the time and effort that would be required for individual investors to make investment decisions regarding which securities to own.  Individual securities (i.e., stocks and bonds) need to be monitored regularly for fundamental changes, and many people do not want to spend the time and effort that is necessary to do so.

3. A third reason why people own shares of mutual funds is to limit risk through broader diversification than might be obtained by investing in individual companies. Many individuals cannot afford to purchase a significant number of shares of more than a few individual companies, and it would be inefficient for them to purchase only a few shares of enough companies to provide adequate diversification.

In this regard, an article in The Wall Street Journal (6-18-06) states,

Both stock funds and individual stocks can post nasty short-term losses. But that’s where the similarity ends. If your well-diversified stock funds take a tumble, you can be almost certain that they will eventually bounce back and deliver respectable returns over the long run. But if your individual stocks take a dive, you can’t be confident of ever recouping the loss, no matter how long you wait.

After deciding that you want to invest in one or more mutual funds, the next decision is what type (or types) of mutual funds you prefer. Of course, it would be nice if there were a mutual fund that would achieve maximum capital appreciation when securities prices are rising, safeguard capital against loss when securities prices are declining, and provide a high income at all times. However, this ideal fund does not exist.

Furthermore, there is no single fund or even type of fund that would be the best for everyone. Based on your own investment objectives and tolerance for risk, you need to choose from among the many types of mutual funds that are available.

Therefore, you need to decide which investment objectives is most important to you. While you are deciding, be sure to keep in mind that the greater the potential for reward (i.e., high returns) the greater will be the risk, especially for periods of less than ten years. Investment objectives to be considered include the following:

  • Long-term capital appreciation
  • Current income
  • A combination of long-term capital appreciation and current income
  • Stability of capital
  • Liquidity

One of the best sources of information regarding the investment objectives of a mutual fund is the prospectus of the fund, which can be obtained from the mutual fund management company itself or from a firm that sells mutual fund shares. Most, if not all, mutual funds have an “800″ (i.e., free) telephone number you can call, and an E-mail address. Other sources, such as Morningstar, can be found at the public library. These sources can provide you with the investment objectives and much additional information for dozens of mutual funds.

If you decide to invest in mutual funds and want to beat inflation over a period of years, you will need to take some risk by investing in mutual funds that own stocks, because if you are too conservative, you are not likely to achieve a return that exceeds the long-term rate of inflation, especially after income taxes. However, if you may need to withdraw some of your money in only a few years, you would be prudent to have an ample funds available in one or more types of short-term investments, such as a money market fund or a short-term bond fund.

Stock risk is diversified — and thus reduced at least somewhat — by investing in almost any equity mutual fund  However, it can be further diversified by making sure that your mutual fund investments represent significant ownership of stocks in three broad sectors:  large companies, small companies, and foreign companies.  In contrast, bond risk would be increased by investing in mutual funds that own bonds of small companies or foreign companies, especially those with low bond ratings or no bond ratings.

It is often advantageous to deal with a single mutual fund management company that offers a variety (or “family”) of mutual funds. This gives you the freedom to transfer your money easily from one type of mutual fund to another, usually for little or no fee. However, every time such a transfer is made for a taxable account, a taxable gain or a loss will need to be recognized, just as if the shares in a fund at one mutual fund management company were being sold and the proceeds were invested in a fund at another mutual fund management company.

Some investors may want to consider lifecycle funds. The Wall Street Journal (9-24-06) provides the following perspectives regarding this type of funds:

The all-in-one funds called “lifecycle” . . . funds, are aimed at hands-off investors who don’t want to closely monitor their investments.

The all-in-one funds are aimed largely at investors saving for retirement, promising a simple alternative for people who feel overwhelmed by the range of options in their 401(k) plan.

“Lifecycle” funds . . . shift to a more conservative blend with less stock as they move toward a specific “target date”. . . .

In shopping for an all-in-one fund, note that two funds with the same target date or risk label can have very different allocations to stocks and bonds.

Fees are another key consideration. Investors should avoid funds that charge extra fees on top of the expenses of the underlying funds.

While many investors may be wary of devoting all their savings to a single fund, investors who generally don’t keep track of their investments should indeed use lifecycle funds that way, advisers say. These products “really are designed to be a one-stop shop,” [according to one retirement consultant].

Another important consideration regarding lifecycle funds is mentioned in a Wall Street Journal article (1-11-09) that stressed the importance of being aware of the differences in asset allocations by these types of mutual  funds.  Some lifecycle funds take greater risks as a result of higher weightings of stocks in specific categories (e.g., foreign stocks) or stocks in general, and/or by making aggressive bets even with bond holdings, which may include risky credit derivatives.