Are Mutual Funds a Good Investment?

The right one for the right reason definitely can be.

Mutual funds listed in a newspaper.
Mutual funds make great investments for most people.. PerryMastrovito/Stockbyte/GettyImages

Mutual funds are a very popular type of investment - but are they good investments? The answer depends on the particular mutual fund you are talking about, and on how much work you did to determine if the fund fits with your goals and objectives.

Here are the six things you need to know to determine what types of mutual funds might be a good investment for you.

1. What is a mutual fund?

First, you need to understand what a mutual fund is.

There are over 7,000 mutual funds, each with a different goal and objective. Some invest in bonds, some in stocks. Some are balanced funds owning both bonds and stocks.Some are conservative, some are aggressive. Some are structured to produce dividends and interest income, others invest for growth. 

To pick a mutual fund that will be a good investment for you, you have to define your investing goals and objectives. For example, if you're not planning on using the funds for a long time, you can focus on long-term growth. If you don't like risk or need to use the money in the next few years you'll want to focus on safety. If you pick a growth fund when you needed safety - or vice versa - then the fund is not likely to end up being a good investment for you.

One of the advantages of a mutual fund is it allows you to capture the returns of an entire segment of the market without having to buy and sell individual stocks and bonds.

For example, if you bought an S&P 500 index fund you would experience the historical stock market returns of the S&P 500, without having to buy all 500 stocks. This ability to diversify across many investments with the purchase of a single fund is one of the main reasons mutual funds are so popular.

2. How do mutual funds charge?

The lower the investment expenses you pay, the higher your returns. You can study the cost of a mutual fund by looking at the fund's expense ratio which is always disclosed in the funds prospectus - and today can usually be found online.

You'll want to look for funds that have low fees (ideally less than 1%). Your time is better spent doing this type of research than trying to find funds that had the highest returns last year. Last year’s results are no indication of what might happen this year. You want a fund that consistently invests according to its goals and objectives and has low fees.

3. Is there a way to find the best funds?

Morningstar is a company that provides statistics and research on mutual funds. Once you have narrowed down the type of fund that matches your goals, their research shows there is a proven way to find funds that are most likely to have the best performance. It is by finding funds in each category that have the lowest fees. For example, if you want an international growth fund, don't look for the fund that had the highest return last year, look for the international growth fund that has the lowest expense ratio.

4. What is the difference between active and passive funds?

It pays to learn the difference between active and passive investing. In a nutshell, actively managed mutual funds trade in and out of securities, while passive funds buy and hold a specific collection of securities. Although from year-to-year some actively managed funds outperform their passive counterparts, academic studies show that over the long term, as a group passively managed funds outperform their actively managed peers.

5. How do you use mutual funds most effectively?

Mutual funds can be quite an effective investment when used to build a portfolio that follows an asset allocation model. In simplified terms, your asset allocation model tells you how much of your money should be in stocks verses bonds, and then within stocks how much should be in U.S. stocks verses international stocks.

Once you have an allocation model you would pick a mutual fund family to work with. I’d recommend you start with my best index fund list. You then pick a mutual fund to fill in each asset class; for example an S&P 500 index fund for U.S. stocks, an international equity index fund to fill in the international piece of your portfolio, and a total market bond index fund for the bond portion.

This asset allocation plan should match your goals. If you are investing retirement money that you won’t need to touch for twenty years, you can pick a more aggressive fund like an equity fund, and leave it alone. If you are retiring in a few years then having all your money in an equity fund may not be such a good idea. Instead, you may want to look at a balanced fund. It can be helpful to use an investment risk scale to classify funds and match them to your goals.

6. Are mutual funds a good choice in retirement?

Some mutual funds are designed to produce monthly or quarterly income. Several mutual fund families have created a series of retirement income funds for this purpose. I think these are good options for someone in retirement who wants to manage their own money.

Other mutual funds called dividend income funds focus on maximizing income by selecting dividend paying stocks.

Most types of mutual funds can be a good choice in retirement if you chose them as part of a holistic retirement income plan, and know how and when to rebalance them, or sell shares as needed to generate the cash you'll need to withdraw.

Bottom line: mutual funds are a good investment if you pick funds with low fees that match your goals and objectives.

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