9 Great Reasons to Own Funds

Editor's note: This article is adapted from Kiplinger's Mutual Funds 2007 guide. Order your copy today.

Mutual funds really boil down to one thing: financial power. With funds, you can harness some of the world's best investment minds, and you can buy everything from small-company stocks to big-company stocks to foreign stocks to bonds to real estate. You also get the power of diversification, which ensures steady returns. With some funds you can even, in effect, hire experts who will manage a whole portfolio for you.

Of course, power comes at a price. But in the case of mutual funds, that price can be dirt cheap. You can start investing for just a few hundred dollars in some cases, and you'll pay experts pennies on the dollar annually to manage your investments.

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Recognizing these extraordinary benefits, about 96 million investors have poured $10 trillion into funds. If you're a stranger to funds, or you need a refresher course, here are the top nine reasons to own them.

1. Cash in on big returns

Over time, stocks of big companies have made about 10% per year, on average, and stocks of smaller companies, about 13% a year. Compare that with the sub-5% return from a bank account or even short-term Treasury bills, and funds that invest in stocks and bonds blow away the competition.

Of course, you may think you can do better than the best fund managers by buying individual stocks. That's possible, but you're not likely to beat their returns when you factor in risk. Once you consider the reduced risk that comes with investing in a broad portfolio, the returns look better and better.

2. Hire top-notch help

When you invest in a mutual fund, you hire professionals. These pros don't dabble in stock picking on evenings and weekends; they do it full-time. And they don't get their tips by tuning in to Jim Cramer on Mad Money. Pros have access to company management as well as reams of stock analysis and more advanced technology than Yahoo Finance.

Mutual fund managers level the playing field between the experts and the amateurs. Some of the best money managers in the business offer mutual funds. Take a look at the two Bills: Bill Miller, who bested Standard & Poor's 500-stock index 15 years in a row at Legg Mason Value, and Bill Gross, who is known as the king of bond investing. They handle money from pension funds, wealthy clients and average fund investors like you. Hundreds of other fund managers have earned impressive records, too—though for every star, there are ten mediocre or poor managers.

You live a busy life. Do you have time to pore over market data and fiddle with your portfolio every day? Probably not. Professional management frees you to focus more on the things you really care about.

3. Diversify for cheap

Managing a big portfolio of individual stocks and bonds is expensive, and trading costs can quickly eat up your profits. By comparison, funds are cheap.

You can find plenty of good funds that invest in large-company stocks and charge less than 1% of assets per year. For bond funds, expenses should be even lower.

A 1.5% expense ratio is reasonable for funds that invest in small-company and international stocks. But some of the best funds in these categories cost less. Dodge & Cox International, one of our favorite funds, charges only 0.7% annually.

Small differences in fees have a big effect on your return. Let's say you invest $100,000 in Stock Fund A, which charges a 1% fee, and another $100,000 in Stock Fund B, which charges 2%. If both funds return 8% a year, you'll have $195,250 in Fund A after ten years and only $176,400 in Fund B. That's an $18,850 difference because of a one-percentage-point difference in fees. (For more on fund fees and expenses, see How to Choose Winning Funds.)

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4. Spread your wealth

Dividing your money among different types of investments is called asset allocation. Studies have shown that investing in different types of assets is even more important to your wealth than the specific investments you own.

Simply by investing in a balanced portfolio of stocks of big and small U.S. companies, foreign companies and bonds, you'll reap good returns with less volatility than if you invest in just one or two types of assets. Mutual funds invest in all types of assets, so they make asset allocation easy.

How does asset allocation lower volatility? Here's a simple example: If you invested in a broad selection of large U.S. companies, you would have seen a 22% loss in 2002 but a 29% gain in 2003. But investing half your money in bonds during those years would have cut the 2002 loss to 6%, and reduced the 2003 gain to 16%.

5. Start small

Don't have a lot of cash to start your nest egg? Several fund families, including Ariel Funds and T. Rowe Price, let you begin investing in their funds for only 50 bucks a month, if you contribute monthly. Others allow you to buy in with only $1,000.

6. Expand your horizons

With mutual funds, you can venture outside your realm of expertise to make money. For example, you might not know how international stock markets work, especially those in developing countries, but you can invest in a well-managed fund that buys overseas securities.

Think hedge funds are exciting? Hedge funds are loosely regulated pools of money that use many strategies to make money, and they generally have extremely high investment minimums and fees. You can find mutual funds that use similar strategies, such as James Advantage Market Neutral and Schwab Hedged Equity.

7. Ease yourself in

A technique known as "dollar-cost averaging" means that you invest small amounts periodically -- say, once a month or once a quarter -- instead of investing a lump sum. This strategy is cheap when you use funds because you don't have to pay trading costs as you would if you regularly bought individual stocks.

Another benefit of averaging is that you end up buying more shares when prices are down and fewer shares when prices are up. Also, averaging forces you to invest when the market is taking a beating. Of course, when prices are low is the best time to buy. It also prevents you from investing too much when greed might motivate you to drop a bundle at a market peak.

Many funds allow you to make automatic investments from a bank or money-market account at no charge.

8. Make a quick getaway

When you need your money, you can sell mutual fund shares for free any day the market is open. There's no brokerage commission, as there is with individual stocks. You're also more likely to get a fair price when you sell, because a fund's sale price, which is called the net asset value, doesn't change that much in the short term. Individual stock prices, by contrast, can vary greatly day to day, and you may have to wait to get the price you want.

9. Delegate your portfolio

Even a good fund portfolio needs to be tweaked from time to time. If you don't want to bother, target retirement funds will do the tweaking for you.

With these funds, which are also known as life-cycle funds, all you need to figure out is what year you expect to retire. Then the fund manager invests in a portfolio of other funds and continually adjusts the mix. As you get closer to the target date, your portfolio automatically becomes more conservative. The manager does this by reducing the percentage of stock funds and increasing the percentage of bond and money-market funds. It's a simple path to peace of mind.