Mutual Funds: Disadvantages of Mutual
Funds
Even though there are many advantages to owning
mutual funds, there are several bad things about mutual funds.
- Professional Management
- Did you notice how we qualified the advantage of professional
management with the word "theoretically"? Many investors debate over whether
or not the so-called professionals are any better than you or I at picking
stocks. Management is by no means infallible, and, even if the fund loses
money, the manager still takes his/her cut. We'll talk about this in detail in
a later section.
- Costs -
Mutual funds don't exist solely to make your life easier--all funds are in it
for a profit. The mutual fund industry is masterful at burying costs under
layers of jargon. These costs are so complicated that in this tutorial we have
devoted an entire section to the subject.
- Dilution -
It's possible to have too much diversification (this is explained in our
article entitled "Are You Over-Diversified?"). Because funds have small
holdings in so many different companies, high returns from a few investments
often don't make much difference on the overall return. Dilution is also the
result of a successful fund getting too big. When money pours into funds that
have had strong success, the manager often has trouble finding a good
investment for all the new money.
- Taxes -
When making decisions about your money, fund managers don't consider your
personal tax situation. For example, when a fund manager sells a security, a
capital-gain tax is triggered, which affects how profitable the individual is
from the sale. It might have been more advantageous for the individual to
defer the capital gains liability.
The five mistakes mutual fund investors make
There are five mistakes fund
investors commonly make. "These mistakes are very common, and
investors have a tendency to make the same mistakes over and over
again," he says.
- Chasing performance.
People have a tendency to invest in funds and asset classes that have done
well lately. And while it may seem counterintuitive to avoid that, if you do
buy funds that are doing well you're probably buying into the tail end of
their performance. This behavior can actually cause you to achieve lower
returns or enter into an investment when a fund is starting to lose money.
- Paying commission.
Fund investors who pay commissions to their representatives may believe
they're getting valuable advice, but they're probably actually paying to gain
access to a specific product. Opt for a fee-only adviser instead.
- Paying excessive fund
expenses. The math is simple -- the higher your mutual fund
expenses, the lower your total returns. Investors should pay attention to fund
expenses when buying. You can do a lot of research on your own or hire an
adviser to do that. Advisers can access money managers that individuals can't.
A good adviser may be able to help you invest less expensively.
- Buying funds with high
turnover ratios. Turnover, or the percentage of the portfolio that
is bought and sold each year, is very expensive for investors. It
creates additional taxation and usually comes with hidden transaction costs --
factors that will decrease your net returns. High turnovers may also be a sign
that your fund manager is not confident in his investments or does not have a
disciplined investment strategy.
- Having inadequate
diversification. With mutual funds, you can be "underdiversified or
overdiversified,". Investors sometimes invest large portions of their assets
in a single fund or into several funds that own similar underlying
investments, and that can equal a more volatile portfolio. On the other hand,
overdiversification can water down your results. You're really just increasing
your expenses for having to invest and reducing your return.
Next-->>
Different
Types of Mutual Funds
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