The Pros and Cons of Mutual Funds

First things first: What are mutual funds?

If you're just starting out in the world of investing, it can be awfully overwhelming. Remember the old adage, "don't put all your eggs in one basket"? That's great advice to live by for a first-time investor, or even an experienced investor who wants to minimize his or her risks.

And that's exactly where these funds come in. A mutual fund is a company that pools money from lots of different investors in order to purchase stocks, bonds, real estate, and other assets. The combined holdings of these assets are called a fund's portfolio. When you purchase shares of a fund, you own a piece of all these holdings. With your money divided up like this, you're making sure not to put all your "eggs" in one "basket."

What are the pros of mutual funds?

Mutual funds are a wise place to start for new investors. Even if you have little financial or investing experience, you can still get into the world of the stock market with a relatively small initial investment. It's a convenient way to get a well-diversified package that might otherwise be very complicated and difficult to manage on your own.

Another plus is the professional management you get when you invest in such funds. You don't have to worry about the day-to-day management of your stocks, because you're paying your investment firm to do that for you. These are experienced professionals who manage money for a living, and they (hopefully!) have the skills it takes to handle your money wisely. (This isn't always the case though, and I'll get to that later.)

Lastly, these kinds of investments appeal to so many because of their ease of purchase. Most banks have their own line of funds, so investing in one might be as easy as making a trip your local bank. Since the "price of admission" is often relatively low with them, many first-time investors consider them a good option.

What are the cons of mutual funds?

Of course, mutual funds aren't perfect. As with all things stock market-related, there is some element of a gamble to it. Let's take a look at the "cons" you should consider before investing in mutual funds:

By investing in them, you're putting your trust into the investment firm. Usually, this is the appeal of the fund - you're giving responsibility to those who have experience. But what if your manager doesn't have the experience and knowledge it takes to properly maintain a fund? You may be putting your money into the hands of someone who has the potential to do unwise things with it. Keep in mind - even if your fund loses money, your manager still gets paid.

Many people make the mistake of reading too much into a fund's past performance when trying to predict future performance, when in fact, they should really be looking at the manager.

Imagine these two scenarios:

A previously successful fund gets a new, inexperienced manager.
A previously unpredictable fund takes on a new manager with 15 years of successes behind him.

Experts will most likely tell you to go with the latter scenario and get behind the manager who has a proven track record in volatile markets.
Other downsides to mutual funds are the fees and taxes. Regardless of your fund's performance, you will have to pay annual fees and sales commissions. In addition, you will be responsible for paying taxes on any capital gains your fund might earn you.

To sum it up:

Mutual funds are a great way to invest in a particular industry you have some interest in without having to make a huge initial investment. By doing your research and carefully weighing the pros and cons of mutual fund investing, you can greatly increase your chances of success.

Vitaly Indinko loves to write about financial topics like mutual fund analysis and high yield CDs.