What is a Mutual Fund?

What is a Mutual Fund?

Mutual funds are some of the most popular investment tools for the average investor (i.e. not Wall Street). If you plan to begin socking away money for the future (you freakin’ better), chances are pretty high that a good chunk of your money will be put into a mutual fund at some point.

This factbook (it’s super boring, you can just trust me on this one) from ICI states that professional investment companies had $15.7 trillion dollars invested in mutual funds at the end of 2015. That’s trillion. With a T. That is almost the same amount generated by the entire U.S. economy in the same year.

Obviously, mutual funds are a big deal. If you’d prefer to reduce the chances you’ll lose all of your investment, mutual funds are probably a good option for you.

Diversification

One of the most prominent strategies in investing is diversification. Basically, diversification means you have your money in different types of investments instead of plowing it all into a small handful. The reason you would want to do this is to reduce your risk.

Let’s look at two examples. First, Tom really likes the company, Apple. He likes them so much that he decides he wants to spend all of his investment money buying shares of Apple stock.  This would mean that Tom’s investments are not diversified at all. There is the potential for this choice to go either way. Apple’s stock could continue its streak of almost constantly going up. Obviously, Tom would benefit from this because it means he would make some money. Or, Apple could fail as a company and go bankrupt, meaning the stock price would decrease dramatically, bringing down Tom’s investment. So, Tom’s investment is directly tied to Apple’s performance.

If Apple’s stock price doubles, Tom’s money doubles. If Apple goes out of business, Tom loses all of his money. As you can see, there is potential for both a huge upside and a huge downside. This makes his decision pretty risky.

Our second example is Jill. She’s not willing to take a huge risk on a single company because she knows it has the potential for a huge loss. Instead, she wants to spread the risk across multiple companies, hoping that more will go up than down.  Like Tom, she likes Apple. But, she also likes 9 other companies as well. Because of this, she decides to put 10% of her money into each of these companies’ stocks. This is diversification.

If Apple has a tough time this year and the stock price goes down by 9%, it would only take an average of 1% increase across the other 9 companies to cancel this loss. If Apple goes out of business and her other 9 companies don’t change at all, she still has 90% of her money. However, if Apple’s stock price doubles, she will only gain 1/10 of what she would have gained had she put all of her money into Apple shares. Her chance of winning big goes down, but so does her chance for losing.

Deciding how to diversify isn’t exactly easy for the average person. This article on Investopedia suggests that people should aim to own shares in between 20-30 companies. That’s a lot for you to go out and pick, and then go through the hassle of buying, then trying to keep up with them and deciding when to sell each of the stocks, and finally trying to sell them at the correct price. It’s a lot of work that most people just don’t have the time or ability to take on. Additionally, you’ll probably have to pay for each trade, so if you use a broker that charges $10 per trade, you’re going to be out $400 after buying and selling the shares in 20 companies.

These factors led to the creation of mutual funds. Thank goodness.

What’s a Mutual Fund?

A mutual fund is basically a big pool of money that is used to buy a lot of shares in various companies. Most people can’t afford to just go and buy shares in 100 different companies and then pay the fees associated with doing so. Instead, a mutual fund kind of acts like one big investor on behalf of all of the smaller investors who buy shares of the fund.

I’m going to oversimplify these concepts a lot, but it should cover the gist of it.

Saving You Money

The costs to an individual investor to buy any amount of shares in a stock vary quite a bit, but it’s pretty common to see a flat rate of $5-$10 for both buying and selling through an online broker. So, if you buy 1 or 100 shares of stock in a company, it will cost you whatever the rate is. Let’s just use $10. If you want to diversify quite a bit by buying shares in, say, 30 companies, regardless of the number of shares you buy for each company, it’s going to cost you $300 (30 companies x $10 fee). Then, when you sell them all, it’ll be another $300 because of the fees to sell. If you’re only investing $5,000, you’ll end up losing 12% of that in fees that you won’t get back. That’s a massive hit.

Mutual funds serve to reduce those costs. Rather than having 1,000 people each spend $10 to buy shares in a company, those 1,000 people can pool their money in a mutual fund and buy shares in bulk. Over time, this can drastically reduce the expenses that come from trading and save you a boatload of money.

Mutual fund companies make their money by charging a fee based on the amount of money invested, rather than charging for each sale or purchase. Typically, the fee will be charged as a percentage of the total money you have invested in the fund. A pretty average fee will be about 1% of your total fund’s investment, however this can vary quite a bit depending on the fund. Vanguard, one of the most popular mutual fund companies, charges as low as 0.1% or less on some of their funds. This means that if you have $10,000 invested in a fund, you’ll only be charged $10 for the year. Much better than $10 for each trade.

Spending money still sucks, but at least mutual funds make it suck less.

It’s Easy To Diversify

Another feature in mutual funds is that investing in companies becomes more affordable. In a mutual fund, you are able to purchase partial ownership of shares, rather than only being able to own entire shares. For example, if you would like to be an owner of shares in 30 different companies, and you have $3,000 to invest, you probably wouldn’t want to buy Amazon, which is currently trading for about $840. Almost a third of your money will be in one share, while the other two thirds will be spread across shares of 29 other companies. Probably not the best strategy.

Buying into a mutual fund means that you’ll own a fraction of all of the stocks that the fund owns. This is the “big investor” idea again. The fund can own shares in dozens or hundreds of companies worth millions or billions of dollars. If you choose to invest, you own a share of this portfolio of stocks.

So, for an easy example, if a fund owns stocks in 100 different companies and it is all worth $1,000,000, the $10,000 you invested means that you own 1% of the portfolio, or 1/100 of every share of stock that the fund owns. Your $10,000 can be equally distributed across all of the shares of the fund regardless of each individual share’s price.

Just like a stock (here’s an explanation if you missed the article), buying into a mutual fund is like buying ownership of a company. The difference is that the company you’re buying into owns shares rather than producing goods or offering services.

Should You Invest In A Mutual Fund?

Mutual funds allow the average investor to reduce costs and increase the breadth of ownership. Not only that, investors can save a lot of time by not having to pick each individual company they would like to invest in. Low-cost investing combined with convenience and risk reduction are why mutual funds have been a major part of many people’s investment decisions.

Funds can be tied to different areas of the market, like technology, foreign markets, or really anything you’d like, or they can have a little bit of everything. You have the option to choose what you think is right for you. Mutual funds basically provide you the opportunity to invest in the market as a whole rather than risking it on a few companies. So, as the market you’re interested in moves, your investment moves, too.

If you want to invest, but aren’t sure where to start, a mutual fund is probably a pretty decent choice for you. As always, do your research and find what is best for your situation.

It’s never too early to fund your future.

 

Do you own any mutual funds? Would you recommend them to others? Why? Leave a comment below!

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