Investing in individual stocks and bonds can be risky. It is best if you have a portfolio of many stocks and bonds so that if some of them do poorly, others can offset poor performance through better performance. It takes a lot of knowledge and time and money to assemble a good, well balanced portfolio of stocks and bonds. Constructing such a portfolio is beyond the knowledge of a regular investor.
One method for reducing the risk of investing in individual stocks is to invest in mutual funds. Mutual funds are a professionally assembled and managed portfolios or collections of many different stocks and/or bonds. Any one stock in the fund portfolio comprises only a small percentage of the whole fund. If a stock does not perform well, it can be sold and represents only a small percentage of the mutual fund. Through such pooling, the effect of a bad investment on the whole fund is lessened. In this manner, a mutual fund allows investors to reduce their risk. Mutual funds also allow individual investors to pool their money and buy larger quantities of stock.
Any given mutual fund may be available in a variety of 'types', each of which will come with different rights and costs.
- "A" Share Funds are the most expensive type of share. Fees for buying this type of stock are paid upfront. Management fees are lower since the upfront fee is higher.
- "B" Share -this type of share has deferred sales charges that are paid when the share is sold. Management fees are generally higher for B shares.
- "C" Share -the type of share has a persistent load (fee) for the life of the share
Open-End vs. Closed-End Funds
Mutual funds may be closed or open. Most mutual funds are open-end funds which have no fixed number of shares and the fund manager will buy or sell stocks at will. In contrast, a closed-end fund has a set number of outstanding shares. Closed funds tend to be riskier than open funds because the number of shares are limited which tends to make the value of shares in a closed fund more volatile than those in an open fund. Accordingly, closed funds are generally not the best option for the average investor.
Indexed vs. Managed Funds
There are many different ways that mutual fund managers have come up with to structure the contents of (the stocks and bonds contained within) a mutual fund. Index funds are designed to keep pace or mirror the behavior of a market index. A market index is a sampling of the market as whole and is used to give investors a general idea of how the market is performing. A well-known example of a market index is the "S&P 500", a single number which goes up and down, indicating the health of the stock market as based on the averaged performance of 500 key corporations' stocks. Index funds are not actively managed and generally contain the same stocks that are used to create the index, so they closely follow the index's performance. When the index goes up, the index fund tends to become worth more, and vice versa, when the index goes down, the index fund shares are worth less. Index funds are considered to be moderately risky because they are an average or approximation of the market as a whole. Since index funds closely follow the index, very little managerial decision making is necessary to construct them. Management fees tends to be low as there is no expense required for research.
Managed funds, as the name suggests have someone at their helm, actively monitoring the fund performance. This person makes decisions about what individual stocks should be bought and sold. If a stock is under-performing the fund manager may decide to sell it before fund holders lose too much of their investment. Because there is someone actively managing the fund, managed funds charge a management fee.
Load vs. No-load Funds
Funds are offered as either load or no-load funds. The term "load" refers to a fee that the fund broker (the person selling the fund to you) will get when the fund changes hands. Load funds pay the broker this fee, while no-load funds do not. No-load funds tend to have higher management expenses since there is no fee paid upfront. So, investors will pay more in the long run. Since the stocks and bonds which make up index funds are easy to chose (simply by buying the stocks and bonds that make up various indexes (like the S&P500), index funds are likely to be no-load funds. Actively managed funds, however, may or may not charge a load.
You would think that it is always a good idea to avoid load funds, but this is not always the case. No-load, index funds are on average your best fund choices, but exceptionally well managed actively-managed funds which charge a load may end up profiting you more than no-load funds would. This is to say, the profit you make purchasing a good load fund may more than pay for the load, if the alternative was for you to purchase a no-load fund that didn't profit you as much. You have to be careful in evaluating the risks of purchasing various load vs. no-load funds based on the performance you expect from them and the confidence you are willing to put into the performance projections. You won't know if your guesses were correct until after the fact.