Are Mutual Funds a Good Investment?

Mutual funds offer diversification and convenience at a low cost, but whether to invest in them depends on your individual situation. Here's what to consider when thinking about using mutual funds to potentially grow and help protect your savings.

Investing in just a handful of stocks can leave you exposed to what is called "overconcentration." When one or two stocks that represent a sizable portion of your savings decline, it can have an undue influence on your investment performance. Mutual funds help provide instant diversification since they invest across dozens or sometimes hundreds of individual stocks, bonds, or other securities.

Further, history shows that large groups of stocks tend to ride out market volatility better than individual stocks. For example, when the market is volatile, one poor performing stock may be smoothed out by other stocks that are performing well in the same index, which may help reduce the risk to your overall portfolio than if you were invested in only one stock.

Exposure to different asset classes can help provide another level of diversification since their prices generally don't move in lockstep. When you invest in just one part of the market—say, U.S. technology stocks—you are at increased risk that bad news involving the sector will sink your results. You might also need an investment to serve a specific role in your portfolio, such as generating income or adding stability during periods of market duress.

Mutual funds can provide access to many different parts of the market, even within the broad asset classes of stocks and bonds. Within stocks you can invest in large or small companies, those focused on growth or paying out dividends, and companies located in large developed or emerging market countries. Different classes of bonds include corporate bonds, government bonds, international bonds, and even bonds that help protect against increases in inflation.

In other words, if there's a segment of the market you're interested in investing in, mutual funds likely have you covered.

To replicate the diversification mutual funds offer, it would take a lot of time and effort to buy all the stocks or other securities held in one mutual fund. You might also feel like you need to respond to every twist and turn in the market even when you have years to go before you will need the money and might be better off just staying the course.

Mutual fund managers can do much of that work on your behalf. Because they buy and sell stocks and other securities in large blocks, their transaction costs are generally minimal. When it comes to picking investments, they're guided by disciplined rules, so they aren't subject to the same tug on emotions as individual investors sometimes experience.

When shopping for a specific mutual fund, it helps to decide first on which of the two types of mutual funds make the most sense for your situation. Index funds are generally lower in cost since they only seek to match the performance of the index they track and are comprised of the same investments held by existing market indexes, such as the Standard & Poor's 500^® index of large U.S. companies. Actively managed mutual funds, on the other hand, offer the potential to outperform the market since the fund managers select the investments, including when to buy and sell them. Because they're more active, they tend to cost more than index mutual funds, and while they aim to outperform the market, they can also underperform. 

When comparing two like mutual funds, you might consider the following factors as tiebreakers:

Compare the funds' operating expense ratios—what the fund charges to cover its operating expenses. In addition, be sure to look for any loads—one-time sales commissions—or transaction fees the fund may have.

While historical performance is no guarantee of future results, look at the fund's track record of either matching the market's performance (in the case of index funds) or outperforming it (the goal of actively managed mutual funds).

Fund managers who have managed investors' money through the ups and downs of full market cycles typically have better processes for maintaining their discipline during frothy and turbulent markets alike. This is especially important for actively managed funds.

When a mutual fund sells investments that have increased in price, it will ultimately distribute the profit to investors in cash, which can impact the capital gains taxes you may owe. You can compare each fund's tax cost ratios to see how much its returns are reduced by taxes.

Deciding to purchase a mutual fund is a personal decision that depends on your individual circumstances. If you're unsure, be sure to ask a financial consultant for help.