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We have already reviewed the two major advantages of mutual funds, professional money management and diversification. As a Rising Investment Guru, you must internalize these two important characteristics of mutual funds. If someone were to call you at 2:00 am in the morning and ask, “What are the two principal advantages of mutual funds for investors?” you should be able to be woken out of deep sleep and answer without hesitation, “professional money management and diversification.” With a mutual fund, your investments are diversified instantly. Your $50 monthly contribution buys 20¢ of Nike, 15¢ of Visa, and 25¢ of Home Depot. This diversification provides some reduction of risk that is difficult for an individual investor to obtain on their own. In addition, the professional money managers are working diligently to identify, choose, and monitor the stocks and bonds that populate your mutual fund. They better be working diligently as you are paying them very well to do so.
Another benefit of mutual funds is the initial low outlay of capital. This is a fancy way of saying that you don’t need $500 or $5,000 or $50,000 to invest in a mutual fund. You can start with $25 or $50 per month. Until recently, it was not advantageous to buy individual stocks with less than $500 or more. (Technology is changing this but at a hidden cost. More about this movement later on when we get to stocks.) There are some mutual funds that have minimum investment amounts of $1,000 or $5,000 or $25,000. In general, these are more exotic, sometimes called “boutique” funds, catering to very wealthy investors willing and able to sustain large losses. These are normally funds that we retail investors avoid.
The last major benefit of mutual funds is the PITA factor. PITA stands for “pain in the a**.” With mutual funds, once you have chosen your one or two or three mutual funds, the PITA factor is extremely low. (This gem comes to us courtesy of David Chilton, the author of The Wealthy Barber. I sure wish I had thought of it. Read The Wealthy Barber!) Once you have chosen your mutual fund, there is almost nothing for us investors to do except check them over every six or twelve months. Yes, Dear Students, mutual funds are boring. And not for the last time will we emphasize that in the investment world, boring is good.
What are the disadvantages of mutual funds? As mentioned, one problem is that there literally are too many of them. It is very difficult to choose from the dizzying array of options. However, there is a more significant disadvantage of mutual funds. You may not be surprised to learn that they are not charities, doling out their services for free. Mutual funds are private enterprises that must charge fees and have earnings to survive, just as any other company must do. A more subtle problem associated with the fees that mutual funds charge is the manner in which they are charged. Few investors understand thoroughly how they are being charged. This is very important. We will cover fees in detail in our next section.
The last potential disadvantage relates to the controversy over whether or not the mutual fund money managers are worth the money that we investors pay them. Some critics are damning of the whole industry and state that no mutual fund managers are worth what we pay for them. Others counter that the criticism has been too broadly applied and there are indeed mutual fund managers who earn their salaries. This topic is covered in detail in a later section.