So let’s assume you’ve decided to start saving for retirement, by taking small amounts out of every paycheck and putting them somewhere to grow. But where? Bank accounts don’t pay enough and lottery tickets are too risky, but investments in stocks and bonds have the kind of returns necessary to build wealth over the long term.
A big problem facing small investors is how to diversify one’s assets over many types of stocks or bonds in order to reduce their overall risk. If you are buying individual stocks and bonds, you’d need thousands of dollars in a range of investments in order to be adequately diversified. That is a tall order for most people getting started in investing.
There is another option: mutual funds.
How It Works
A mutual fund pools together the investment funds of thousands of individuals. Armed with the pool of money, the fund manager can invest in many more stocks and bonds and can buy and sell at much lower rates than individuals could do on their own.
There are thousands of mutual funds to choose from: stock mutual funds, bond mutual funds and stock and bond mutual funds.
In fact, today there are more mutual funds on the market than there are individual stocks. This is a mixed blessing. While you have many potential choices, how do you know which one to choose?
Remember Your 401(k)
This might not be as daunting as it appears. If you are investing in a mutual fund through a 401(k) plan at work, you’ll have to choose from a list of approved funds and other options.
Net Asset Value
When you invest in a mutual fund, the share price you pay is based on the fund’s net asset value (NAV). The NAV is calculated each day by dividing the total value of the investment by the number of shares.
Load vs. No-Load Funds
Mutual funds sold through brokers or financial advisors may include a sales commission called a “load.” It is usually a percent of the price and ranges between 3 and 6 percent. If the load is paid when you buy shares, it is called a front-end load. If the load is paid when you sell, it is called a backend load.
No-Load Funds
Funds that do not charge sales commissions are called no load funds. So, generally, most investors favor no load funds over load funds. Financial advisers, however, may try to steer you in the direction of load funds.
Index Funds
All funds charge management fees and expenses that are deducted from the total assets of the fund.
Some mutual funds are called index funds. Managers of stock index funds buy the stocks of companies that match a particular index. The two most widely-followed indexes are the Dow Jones Industrial Average (which tracks 30 stocks), and the S&P 500 (which tracks, you guessed it, 500 stocks). Because following an index is relatively easy, index funds are less expensive than “actively managed” funds, which require more staff and expertise.
Economists often recommend buying index funds. Why? There are few surprises in the stock or bond markets. Most of what there is to learn about various corporations has already been uncovered by financial professionals – - it is, after all, their job to find out.
So, since it is very hard to outguess the market, it might be wise to forget about trying to make a killing in the stock market and settle for the returns offered by index funds over the long term. Over the long run, these gains can offer solid returns.