By: Andrew Altman | SlickBucks.com | May 2017 |
Mutual funds are an easy way to save and invest for retirement. It’s possible to buy many mutual funds with lower increments of money and to reinvest dividends in the mutual fund. That means investors in tax-advantaged mutual funds can also avoid reinvestment risk. Unlike a portfolio of individual stocks and/or bonds, a mutual fund contains many different securities.
The idea behind investing in mutual funds involves diversification. Modern portfolio theory (MPT) advises that by investing in different assets, such as stocks, bonds, and cash equivalents, risk is reduced. Purchasing a mutual fund in an Individual Retirement Account (IRA) or 401k plan helps you to purchase a pool of investments.
Since mutual funds invest in different types of things, it’s important for the investor to decide how much risk he or she is willing to assume. For instance:
• If you like the idea of buying quality stocks and you’re a growth with income investor, you might invest in a mutual fund portfolio of larger blue chip U.S. stocks.
• If you’re risk averse—or you really don’t want to expose your funds to risk in the stock market—you may prefer a short-term Treasury bills mutual fund. Treasury securities are backed by the full faith and credit of the U.S. government.
• If you believe that greater diversification will yield more portfolio growth over time, you might select a wide array of stocks, real estate, bonds, cash equivalents, or other types of securities.
• If you believe in the future of technology and you have years to retirement, you may have the ability to withstand more risk in the market. Look for a high-quality technology mutual fund in that case.
Mutual Funds and Investment Preference
It’s possible to find a mutual fund to match your investment preferences. That’s why it’s essential for each investor to start with risk assessment.
Mutual fund investing allows the investor to purchase a slice of a ready-built portfolio pie. The investor then shares in the mutual fund
gains or losses.
Mutual Fund Management
Many mutual funds are actively managed by a professional fund manager or a portfolio management team. The manager decides what to buy or sell for the fund. Importantly, the manager must make decisions that follow the fund’s investing philosophy recapped in the prospectus. Before investing in a mutual fund, ask the financial adviser to provide a copy of the prospectus. Review the prospectus before investing.
If you purchase an individual fund from one of these providers, the fund family offers options, such as the ability to sell a fund, place proceeds in a cash equivalent fund, or buy a new fund. An employer may pre-select the fund family from which to choose. If you want more choices, it’s possible to open a self-directed retirement plan.
”Instant Diversification” and Mutual Funds
Financial experts talk a lot about the benefits of diversification. Unfortunately, it’s difficult to achieve portfolio diversification if the investor wants to pick individual stock or bond issues.
A mutual fund provides automatic diversification. If the investor doesn’t have a great deal of capital to buy a varied portfolio of stocks and bonds, a mutual fund investment solves the problem.
By pooling capital with other investors, the investor spreads money across a large, pre-built portfolio of investments that reduces his or her risk of getting wiped out by any one bad stock or bond position.
Mutual fund investing also saves a lot of time. By investing in a single fund—or many funds to more fully diversify the portfolio—the investor hires a professional asset manager to monitor investment holdings. The investor doesn’t need to choose when to buy or sell in anactively managed portfolio.
It’s unnecessary to spend time getting quotes or following news feed that effect the day to day prices of the underlying securities in the portfolio unless the investor enjoys doing that.
Index Mutual Funds
An index fund is typically passively managed. In other words, the index fund doesn’t pay a team of portfolio managers to make buying and selling decisions of individual securities in the portfolio (because the fund invests only in specific indexes).
For example, an index tracks a certain part of the stock market, or the wide stock market, without purchasing an actual portfolio of underlying securities. If the sector or wide market rises, the investor participates in the gains. If the sector or market trades down, the investor’s index fund declines in market value.
Of course, as long as the investor doesn’t sell the index mutual fund within the retirement investment account, gains and losses aren’t considered realized. A realized loss in the retirement plan can’t be written off on taxes. Depending on multiple supply and demand factors, the investor can choose to buy more of an index mutual fund to average down his or her cost basis.
One of the most widely known stock indices is the Standard & Poor’s (S&P 500). It represents a wide cross-section of American companies. An S&P 500 index fund buys the S&P 500 index, not the underlying portfolio of stocks.
An index mutual fund is often a low-cost mutual fund investment. Actively managed stock or bond mutual funds often pass on higher costs of managing the fund.
With so many mutual fund choices, the investor should discuss prospective selections with a financial adviser before investing retirement plan funds.
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