Many investors want to diversify their holdings in order to limit their exposure to risk. However, most individual investors cannot afford the fees and commissions necessary to take large positions in a number of individual securities. Fortunately, they can take advantage of mutual funds.

There are a number of benefits to mutual funds, though it is crucial to examine the downsides, as well as your own needs, goals, and risk comfort, to determine whether mutual fund investment is right for you.

Definition of Mutual Funds

Mutual funds are investment vehicles that pool money from many different investors to increase their buying power and diversify their holdings. This allows investors to add a substantial number of securities to their portfolio for a much lower price than purchasing each security individually.

There are two types of mutual funds:

1. Actively Managed Funds. With actively managed funds, professional money managers handpick investments according to the particular mutual funds objectives. These objectives vary widely, but could be investing overseas in small start-ups, focusing on a particular industry (such as oil ), or diversifying between large-cap stocks and bonds .
2. Index Funds. Index funds, on the other hand, are not actively managed, as they simply seek to replicate holdings in an index like the S&P 500.

Advantages of Mutual Funds

Disadvantages of Mutual Funds

Although mutual funds can be beneficial in many ways, they are not for everyone.

1. No Control Over Portfolio. If you invest in a fund, you give up all control of your portfolio to the mutual fund money managers who run it.
2. Capital Gains . Anytime you sell stock, youre taxed on your gains. However, in a mutual fund, youre taxed when the fund distributes gains it made from selling individual holdings even if you havent sold your shares. If the fund has high turnover, or sells holdings often, capital gains distributions could be an annual event. That is, unless youre investing via a Roth IRA. traditional IRA. or employer-sponsored retirement plan like the 401k .
3. Fees and Expenses . Some mutual funds may assess a sales charge on all purchases, also known as a load this is what it costs to get into the fund. Plus, all mutual funds charge annual expenses, which are conveniently expressed as an annual expense ratio this is basically the cost of doing business. The expense ratio is expressed as a percentage, and is what you pay annually as a portion of your account value. The average for managed funds is around 1.5%. Alternatively, index funds charge much lower expenses (0.25% on average) because they are not actively managed. Since the expense ratio will eat directly into gains on an annual basis, closely compare expense ratios for different funds youre considering.
4. Over-diversification. Although there are many benefits of diversification. there are pitfalls of being over-diversified. Think of it like a sliding scale: The more securities you hold, the less likely you are to feel their individual returns on your overall portfolio. What this means is that though risk will be reduced, so too will the potential for gains. This may be an understood trade-off with diversification, but too much diversification can negate the reason you want market exposure in the first place.
5. Cash Drag . Mutual funds need to maintain assets in cash to satisfy investor redemptions and to maintain liquidity for purchases. However, investors still pay to have funds sitting in cash because annual expenses are assessed on all fund assets, regardless of whether theyre invested or not. According to a study by William OReilly, CFA and Michael Preisano, CFA, maintaining this liquidity costs investors 0.83% of their portfolio value on an annual basis.

Are Mutual Funds Right for You?

Considering that there are more mutual funds on the market than there are individual stocks, the chances of finding one right for you are high. That said, mutual funds are most appropriate for people who dont have the time or inclination to be heavily involved in managing an investment portfolio, and dont mind paying an annual expense ratio to have a professional do it for them. Theyre also ideal for people who simply cant afford the level of diversification that most funds offer.

Still, if you seek diversification, but not necessarily professional management, index funds with their low expense ratios may be a good fit.

Final Word

To delve into the world of mutual fund investing requires you to first analyze your own situation, specifically, your needs and goals. Determine what youre investing for and your comfort with risk to assess what types of funds to look at.

For example, if youre choosing funds for your retirement account and have many decades until you reach retirement, a more aggressive mutual fund with low expenses would be ideal. Plus, you arent liable for capital gains tax on investments in qualified retirement accounts, so you could consider funds with high turnover that annually distribute capital gains.

On the other hand, if youre saving to purchase a home within the next decade, you may prefer a fund that doesnt often distribute capital gains and isnt as aggressive as your retirement holdings.

To start searching for and comparing mutual funds based on risk, performance, expenses, and more, try the free fund screener at Morningstar.com .