What are mutual funds and how can you invest in them?

What are mutual funds and how can you invest in them?

Mutual funds can be incredibly beneficial for those who are busy managing their own businesses or work 9 to 5 jobs and are looking for ways to increase their savings. 

Mutual funds are professionally run businesses that gather money from investors and trade stocks, bonds, indices, and other financial assets to generate a profit for their investors. 


Things You Should Know About Investing in Mutual Funds

  • Investing in mutual funds is much safer than trading financial instruments on your own
  • Mutual funds are professionally managed
  • Mutual funds come in different shapes and forms, making it easier to choose the one that best fits your needs
  • Mutual fund managers have amazing salaries, which might tempt you into changing your career
  • Investing in mutual funds can be a great way to increase your wealth by compounding
  • In some countries, mutual funds can provide a legal way to be exempt from wealth taxes

Why Investing in Mutual Funds Makes Perfect Sense for Most

Investing is complicated for many reasons. Finding good investment opportunities is difficult and managing your risk is the biggest challenge. In order to save time and energy, people entrust their money to professionals that invest in low risk, diversified portfolios and compound the profits. 

"And I think the more money you put in people's hands, the more they will spend. And if they don't spend it, they invest it. And investing it is another way of creating jobs. It puts money into mutual funds or other kinds of banks that can go out and make loans, and we need to do that." - Michael Bloomberg

Mutual funds manage money much better than regular retail traders

It is estimated that 70-97% of retail traders lose money in the financial markets. The reasons vary. Some of the biggest reasons are low levels of education, lack of discipline, lack of good money management, and laziness. 

Quality education is essential when it comes to investing. Each trade has the possibility of going in your desired direction or taking a turn for the worst. Risk management should include measuring those possibilities and coming up with suitable risk/reward ratios. 

Generally, trading systems make money based on 3 scenarios:

  • If your trading strategy has a 60% probability of making money and the setup presents itself often, it makes sense to risk a very low percentage of your balance each time and place lots of orders. Over time, the edge that your strategy gives you will translate into slow gains
  • In the case that a trading strategy has an 80-90% probability of success, it makes more sense to risk higher percentages and make fewer trades. Usually, great setups hardly show up on the charts, but when they do, your equity chart will have sharp moves with the potential for huge gains
  • If the probability of success is a 50/50 bet, there’s no other option but to only trade setups that offer low risk and high reward ratio

These ideas are simple. Yet developing strategies, testing, and upgrading them to always stay on top is very difficult. What’s more, even when traders create great strategies, there are always issues stemming from discipline. A good trader trades like a robot. No greed, no fear, no excitement, or other human emotions. You might ask this question, “if robots are so great, why don’t we let algorithms make all the decisions?” Well, algorithms have their limitations. Namely, they can’t take into account fundamentals like political turmoil, press statements, and more.

What’s more, becoming a consistently profitable trader requires a lot of time and tireless work. As you can see, it’s not easy to make money in the financial markets, which explains why so many people blow up their trading accounts without ever making a cent in returns. If you can’t spend enough time and resources on trading, maybe it’s a good idea to invest in something else or let mutual funds do the work for you.

You can choose a mutual fund based on your risk tolerance and other preferences

When it comes to mutual funds, there’s a large pool of various funds you can choose from. Funds differ based on their minimum deposit requirements, risk exposure, and asset class policies. What’s more, some mutual funds enable clients to gradually deposit savings just like pension funds do.

In terms of asset-class investments, there are 7 types of mutual funds. 

  • Money market funds. These funds are invested in government bonds, treasury bills, commercial paper, and deposit certificates. Such investments are considered very safe, but the return on investment is generally very low
  • Fixed-income funds buy and hold assets that offer fixed returns like government bonds and corporate bonds. It’s worth mentioning that government bonds are usually safer as governments are backed by countries. As a result, safer investments lead to lower returns
  • Equity funds invest in stocks. There are various types of equity funds, such as ones that specialize in growth stocks, income funds, value stocks, large mid and low-capitalization stocks, etc.
  • Balanced funds invest capital like equity funds and fixed-income funds put together. Balanced funds diversify their portfolio. As a result, investments are less risky than the ones made by pure equity funds but much riskier than ones made by pure fixed-income funds
  • Index funds invest in indices. Generally, index fund managers have much less work to do as there are a limited number of indices to analyze and invest in. Therefore, index funds have smaller fees
  • Specialty funds specialize in commodities, real estate, socially responsible areas, etc.
  • Fund-of-funds invest in other funds. This type of investing is also known as multi-manager investing

A tool to compound your savings

Compounding is the most important aspect of wealth creation. Its power is often not well understood. It takes time to get rich using compounding, but it's a time-tested method and the closest thing to getting rich quickly. 

Let’s say you invested $100k in an asset that returns 10% of your initial investment annually. Instead of cashing out, you reinvest your $10k of profit along with your initial $100k. So now your market position is $110k. Next year you receive 10% of $110k. This is called compounding. Each year your returns grow, and you are becoming wealthier. In general, it’s important to make sure that whatever you are investing in should have a higher reward potential than the percentage of annual inflation. 

Mutual funds are a tool to passively invest in financial markets and at the same time get a great opportunity to compound your returns.

Additional Details About Mutual Funds

Many mutual funds are accessible by investing as little as $100. Mutual funds are made for the general public. They offer low risks, low fees, and low minimum deposit requirements. Many people use mutual funds to save for college or for retirement.

How to choose a mutual fund

Since you are offered many different kinds of mutual funds, it’s going to take a while to find one that suits your interests the best. 

Firstly, you should make a list of your preferences. Are you in for the long game or do you want to cash out in a couple of years? What’s your risk tolerance? What’s the minimum amount you have to start investing with? Is the fund investing in small-cap or large-cap stocks? 

The historic performance of the fund is another important issue. It’s not guaranteed that past performance will be repeated, but experienced management can increase the likelihood of success.

It should be noted that generally, management fees for mutual funds are low (around 1 to 2 percent of your deposit). Shop around to see the best offers on the market. 

Comparing Investing in Mutual Funds With Other Forms of Investing

Mutual funds offer great investment opportunities. However, there are many investment options available out there. So let's compare mutual funds to some of the other most popular forms of investment.

I think you'll do as well as most professionals. Most professionals don't beat the market. Let's not over-rate my industry. But if you have time, you can be in good mutual funds that have good records.” - Jim Cramer

Mutual funds vs real estate

Real estate investing is often viewed as a great way to protect yourself from inflation. However, this type of investment comes with certain challenges, mainly liquidity. It’s much easier to buy and sell a stock than it is to sell a house. Challenges in liquidity make real estate investments difficult to compound. 

What’s more, real estate markets are characterized by boom and bust cycles. If you are considering buying a house, it’s better to do it in times of a recession. 

For real estate developers, demand goes down every time central banks increase interest rates. Buying a house is the biggest expenditure in our lives. Average home buyers take out loans to fund their real estate investments.

Let’s not forget taxes. In many parts of the world, real estate is heavily taxed. Whereas investing in mutual funds represents a tool for tax evasion. Governments usually try to encourage citizens to invest in mutual and pension funds by lowering those taxes. Putting your savings into these funds enables reinvesting and compounding which slowly increases wealth over time. 

Mutual funds vs investing on your own

As mentioned before, most traders blow up their accounts due to a lack of experience and discipline. However, for some traders that are dedicated to investing, it makes total sense to trade all on their own. 

When you are using your own logic and reason to make trading decisions, you have the opportunity to try out trading different asset classes. Investing can be fun for many. It can provide a feeling of fulfillment in life. Moreover, you don’t pay someone else to manage your money, and it’s a big deal, as mutual fund managers are generally paid generously.

Furthermore, It’s easier to double $1,000 than it is to double $1,000,000 in the markets. Price slippage is a smaller concern for small account holders than it is for institutional traders. 

Mutual funds vs hedge funds

For many novice investors, mutual funds are hard to differentiate from hedge funds. Both have some similarities, but they're wildly different. 

They both are managed professionally, collect capital from a large number of investors and invest in financial instruments. Fees are predetermined and largely influence the nature of the funds. Now let’s see the main characteristics of each type to better understand the differences.

Mutual funds: 

  • Mutual funds don’t take any share of your profits. This translates into the manager's motivation to provide safe and steady results
  • It’s easy to invest in them. Accessible for the general public
  • Charge a low management fee (usually 1-2% of your deposit)
  • Generally performs worse than hedge funds in terms of Return On Investment (ROI)

Hedge funds:

  • Take 10-30% as a performance fee from the profits. The amount is predetermined and usually the better the results, the higher the percentage that is taken
  • Are only available for high net worth institutions and individuals
  • Charge approximately 2% management fee
  • Can make riskier investments
  • Have better ROI than mutual funds but are more exposed to risk

Hedge funds are more actively trading different assets. Whereas with mutual funds, investments tend to be kept for years.

What Did We Learn From This Investing in Mutual Funds Article?

Mutual funds are passive forms of investment. They are widely used by the general public for investing, compounding their savings, and increasing wealth. 

Mutual funds are low-risk, low-reward financial institutions. Mutual funds vary in terms of how they invest, where they invest, and how much management fees they charge. Mutual funds are not directly motivated by your account growth as they don’t take a cut from returns.

FAQs About Investing in Mutual Funds

Why do people invest in mutual funds?

Investing can be a real challenge for most people. In general people with savings are busy working 9-5 jobs and have very little spare time to study investing. Mutual funds help people with no time or expertise to invest in financial markets.

Who can invest in mutual funds?

Everyone can invest in mutual funds. Even children with help from a parent or a guardian. Some of the mutual funds require as little as $100 to get started. 

How profitable is investing in mutual funds?

Mutual funds vary in terms of risk exposure and asset classes. In general, mutual funds are considered low-risk investments. And as you may already know, low risk usually translates into low returns. 

Are mutual funds and Hedge funds similar?

While they have some similarities, they are widely different in many key aspects. Mutual funds are for the general public. Whereas hedge funds collect capital from high-net-worth investors. Mutual funds have lower risk/reward ratios compared to hedge funds.