The suitability of an open-end fund, closed-end fund, exchange traded fund (ETF), or unit investment trust (UIT) is closely tied to the securities held in its portfolio. For example, the suitability of a large-cap stock fund is generally similar to the suitability of large-cap stocks.
The main differences between funds/UITs and the individual securities they hold are:
Funds and UITs provide instant diversification. It’s common for a mutual fund portfolio to hold dozens - or even hundreds - of different securities. Rather than researching and selecting individual investments, an investor can buy a fund or UIT and have a professional manage the portfolio on their behalf. This can be especially useful for retail investors who don’t have the time or expertise to build and monitor a diversified portfolio.
That professional management and diversification come with costs. These products may include an expense ratio, sales charges, 12b-1 fees, management fees, and other expenses. Even when the benefits outweigh the costs, you still need to consider fees when evaluating and comparing these investments.
Dollar cost averaging is a common investment strategy used with investment companies, especially mutual funds. It means investing a fixed dollar amount at regular intervals over time (for example, $1,000 each month). This approach helps reduce market timing risk, which is the risk of investing a large amount right before a market decline.
For example, if an investor made a $100,000 investment right before the Great Recession of 2008 (such as in the summer of 2007), it would’ve taken over 4 years to recoup losses from the downturn. The larger the lump-sum investment, the more exposed the investor is to a sharp decline soon after investing.
Now compare that to investing the same $100,000 as $1,000 per week over 100 weeks (roughly 2 years). When prices fall, the same dollar amount buys more shares. That’s the key mechanism behind dollar cost averaging.
In a fluctuating market, this often leads to an average cost per share that’s lower than the simple average of the share prices paid. Here’s an example during a market decline, using ABC mutual fund:
| Date | Purchase amount | Price per share | Shares purchased |
|---|---|---|---|
| Jan 1 | $1,000 | $20 | 50 |
| Feb 1 | $1,000 | $16 | 62.5 |
| Mar 1 | $1,000 | $10 | 100 |
| Apr 1 | $1,000 | $8 | 125 |
Over four months, the investor invested $4,000 and purchased 337.5 shares. Now compare the average cost per share to the average price per share.
Average cost =
Average cost =
Average cost = $11.85
Now, average price:
Average price =
Average price =
Average price =
Average price = $13.50
The average cost reflects both the prices paid and the number of shares purchased at each price. The average price is just the simple average of the share prices.
In a declining market, dollar cost averaging tends to lower the average cost because the fixed investment amount buys more shares at lower prices. This doesn’t eliminate market risk, but it can reduce the impact of investing a large amount at an unfavorable time.
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