Considering all the investment opportunities available today and how easy it is to simply trade individual stocks online, why should you consider investing in a stodgy mutual fund? Do your friends or co-workers ever discuss mutual funds with outstanding long-term performance, or do they brag about the penny stocks they buy and the exciting world of commodities?
Despite all the excitement over alternative investments and day-trading stocks, a good mutual fund is often the best choice for building long-term wealth. While mutual funds have many advantages, two of the most important include diversification and discipline.
One of the most important benefits of investing in a mutual fund is gaining instant equity diversification. While you won’t be completely diversified with just one equity mutual fund (no bonds, etc), you will reduce your overall investment risk by holding between 30-400 stocks rather than trying to keep track of 5-15 in your own portfolio.
Think about it this way; if you tried to do all your own research and buy individual stocks, you may be able to keep track of up to 20 stocks or so in your spare time. However, if even one of those 20 companies suddenly declared bankruptcy, your portfolio would drop by 5%. However, if you purchased a mutual fund holding 300 stocks (an amount which you could never monitor on your own) and one declared bankruptcy, you would never notice. This is the benefit of the instant diversification of a mutual fund.
The second most important benefit of mutual funds is the fact that you are “forced” to be more disciplined in your investing. Research performed using data from online trading accounts has discovered that the more the average individual investor trades, the lower his returns. Aside from poor security selection, the active trader also incurs substantial trading costs.
Stocks and ETFs are so easy to trade throughout the day that many investors are harmed by trading too much. Mutual funds, however, are structured so that you can only buy or sell your shares at the close of each trading day, thus reducing turnover and trading costs.
Also, since mutual funds are typically run by experienced, professional managers, we would expect that they would have a more disciplined investment methodology than compared to the average individual investor. Theoretically, professional managers would be able to generate better investment returns due to this methodology and investing discipline.
While mutual funds provide many benefits to the average investor, two of the most important are diversification and discipline. By investing in a mutual fund with a diversified, long-term, and disciplined methodology, a mutual fund can help you trade less, reduce trading costs, and generate higher returns than investing in individual stocks on your own.