Are mutual funds a good investment?

Mutual funds give investors exposure to a basket of assets that can include stocks, bonds or other securities, without requiring them to pick each investment on their own. Like any other investment vehicle, though, mutual funds come with both benefits and risks. Understanding how mutual funds work – and how they compare to other investments – can help you decide if they’re the right fit for your financial goals.

In this article, we’ll cover what mutual funds are, their pros and cons, and how they stack up to other investment options.

What are mutual funds?

A mutual fund is an investment vehicle that pools money from multiple investors to invest in a portfolio of assets that can include stocks, bonds and other securities.

When you invest in a mutual fund, you’re buying shares of the whole fund, not the individual assets it holds. This structure can be appealing because it eliminates the need for investors to research and manage their investments themselves while still providing exposure to a broad portfolio.

Mutual funds are overseen by professional portfolio managers who decide which investments to buy and sell based on the fund’s overall strategy. Some funds aim to beat the market through active management, while others passively track an index like the S&P 500.

Advantages of investing in mutual funds

The following benefits make mutual funds a popular investment choice:

Professional management

When you invest in a mutual fund, your money is in some cases overseen by portfolio managers who are registered with the U.S. Securities and Exchange Commission (SEC). These individuals make decisions about which assets to buy and sell based on the fund’s overall investment strategy. This oversight can be especially helpful if you don’t have the time or experience to manage your investments on your own.

Diversification

Mutual funds invest in a wide range of assets, so your money isn’t tied to the performance of a single company or security. This built-in diversification can help reduce your overall risk and stabilize your returns over time. Even if one investment within the fund performs poorly, gains in other areas can help offset those losses.

Low minimum investment

Getting started with mutual funds likely doesn’t require a large amount of money. Many funds have low minimum investment requirements, making them accessible to many types of investors.

Liquidity

Most mutual funds are considered relatively easy to buy and sell. While they don’t trade throughout the day like stocks or exchange-traded funds (ETFs), you can typically redeem your shares at the end of each trading day. This daily liquidity is generally perceived to provide flexibility if you need quick access to your money or want to make changes to your portfolio.

Securities and Exchange Commission (SEC) regulated

Mutual funds are regulated by the SEC, and they are required to follow strict rules regarding the safekeeping of fund assets, which provides a level of investor protection.

Disadvantages of investing in mutual funds

While mutual funds offer many benefits, they do have limitations. It’s important to understand the drawbacks before you invest.

Potential for losses

All investments involve risk, and mutual funds are no exception. If the securities held by the fund decline in value, your investment can lose money. This is true even for diversified funds, since market-wide downturns can affect many types of assets at once.

Not insured by the Federal Deposit Insurance Corporation (FDIC)

Unlike savings accounts or certificates of deposit, mutual funds are not insured by the FDIC, so there’s no government protection if the fund loses value. Even funds that invest in lower-risk assets like bonds or money market instruments still carry some level of risk.

Fluctuating dividend or interest payments for funds that pay them

Some mutual funds pay out dividends or interest, but these payments can vary based on market conditions. For example, if interest rates fall or the companies held by the fund reduce their dividends, the income you receive could decrease. Unlike with fixed-rate bonds, mutual fund payouts won’t necessarily stay the same over time.

May come with higher fees than other types of funds

Some mutual funds, particularly actively managed ones, may come with higher fees than passively managed funds, like passively managed ETFs. If the performance of the fund doesn’t justify its fees, this can impact your return on investment.

Can only be traded at end of day

Mutual fund shares can typically only be traded at the end of the trading day. This might not be a problem for buy-and-hold investors, but for those who like to trade throughout the day, this may be an issue, as it limits their ability to react to market fluctuations in real time.

What are the different types of mutual funds?

As you consider the pros and cons of mutual funds, you may want to assess different types of mutual funds as you decide where to invest. There are many kinds of mutual funds, each with its own investment objective and risk profile. Here’s an overview of some common mutual fund types:

Stock-focused funds

Stock funds, also known as equity funds, invest primarily in shares of publicly traded companies. These funds might focus on specific sectors – like health care or technology – or companies of a certain size – like those with small-cap or large-cap stocks.

When you invest in a stock-focused fund, you’re buying a piece of many individual companies. If those companies perform well, the share prices will rise, pushing the value of the fund upward as well.

On the flip side, stock prices can fall quickly depending on company performance, market sentiment, interest rates and economic news. Because a stock-focused fund is tied to the ups and downs of the stock market, its value may fluctuate from day to day, even if the fund holds dozens or hundreds of different stocks.

Index mutual funds

Index mutual funds are designed to mirror the performance of a specific market index, such as the S&P 500 or the Dow Jones Industrial Average. Instead of trying to beat the market, these funds aim to match the returns of the broader market by holding all the securities measured in a given index.

One of the biggest advantages of index funds is their low cost, as they generally require minimal day-to-day management. As a result, the cost to invest in them may be much lower than the cost to invest in an actively managed fund.

One risk to be aware of with these funds is that because index funds are tied to a specific benchmark, they don’t adjust their holdings based on market conditions. Even if a company in the index is underperforming, the fund will continue to hold it until the index changes.

Bond-focused funds

Bond-focused mutual funds invest in bonds and other debt securities. When you buy into a bond fund, you’re essentially lending money to governments, municipalities or corporations in exchange for regular interest payments. The fund collects these payments and either distributes them to investors or reinvests them on behalf of investors in new bonds.

Bonds may be more stable than stocks because they offer fixed interest payments and a set repayment timeline. They also don’t typically rise and fall as sharply as stocks, so bond funds can help balance out the risk of a stock-heavy portfolio, especially during market downturns.

While bonds tend to be less volatile than stocks, they aren’t without risk, and you can lose money investing in them. The value of existing bonds tends to decrease when interest rates rise, and bonds are subject to credit risk if the bond issuer can’t repay its debt.

Money market funds

Money market funds invest in short-term debt securities, cash and cash equivalents. They tend to be low risk compared to other types of mutual funds, but their returns are typically lower. The goal of a money market fund is to preserve your principal while earning you a modest return.

Unlike stock or bond funds, money market funds prioritize safety and liquidity over growth. They’re designed to keep their net asset value (NAV) as close to $1 per share as possible, making them a popular choice for investors who want easy access to their money.

Comparing mutual funds to other investment options

Mutual funds are just one of many ways you can invest your money. Read on to learn how they compare to other popular investment vehicles.

Individual stocks

When you invest in mutual funds, you’re buying a diversified portfolio of assets, which can help spread out your risk. In comparison, investing in individual stocks gives you shares of ownership in a single company. While individual stocks can offer higher potential returns, they may come with more volatility. Mutual funds may be overseen by professional managers, making them a good choice for those who prefer less day-to-day involvement with their investments and letting someone else do the work.

ETFs 

ETFs trade like stocks, meaning you can buy and sell them throughout the day. Mutual funds, however, are priced only once per day, after the market closes. Mutual funds can have varying fees, but ETFs are known for being cost-effective investment vehicles that often have low expense ratios. Mutual funds might be a better fit for those who prefer to invest in actively managed funds and don’t need access to real-time trading, but there are also clear reasons to invest in ETFs.

Certificates of deposit (CDs)

CDs are low-risk, FDIC-insured products designed to preserve your capital. They offer steady, though relatively low, interest rates. Mutual funds are not insured and can lose value, but they can also offer greater potential for long-term growth. For short-term goals or emergency savings, a CD could be a better choice, while mutual funds might be better for long-term investing.

Steps to take before investing in a mutual fund

Before you invest, you may want to take the time to understand a mutual fund’s strategy and how it fits into your overall investment strategy. The SEC recommends doing the following as you weigh an investment:

Review the fund’s available materials

Start by reading the fund’s prospectus and its most recent shareholder report. These documents provide important details about the fund’s investment goals, holdings, fees, risks and past performance. You can find them on the fund’s website or through the SEC’s EDGAR database.

Consider your overall financial goals

Any mutual fund you select should align with your financial goals, investment timeline and risk tolerance. For example, a stock fund focused on growth might be better for long-term goals like saving for retirement, while a money market fund might make more sense to build emergency savings.

Ask questions if you have them

When you invest in a mutual fund, you’re handing your money over to a fund manager to invest on your behalf. It’s essential that you understand where your money is going, how it’s being invested and how you can get it back. Ask questions if anything is unclear – you should feel confident in your understanding of the fund before investing money in it.

The bottom line

Mutual funds can be a good option to grow your money over time, especially if you’re looking for a professional to oversee your investments. Mutual funds, broadly speaking, can be suitable for novice and experienced investors alike, with a range of fund types to suit different goals and risk levels.

Mutual funds are not without risk, however, and they also aren’t insured against losses. Before investing, take time to review the prospectus, understand any fees and consider how the fund fits within your broader financial strategy.

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