Investing 101: Mutual Funds

(Welcome back!  I hope you are ready for some learning, as we are going to cover the wonderful world of mutual funds.  Hold onto your hats, it’s going to be a wacky ride.)

Q: What are mutual funds?

A: Mutual funds are companies that buy a variety of other investments, such as stocks, bonds, and REITs.  Shares of the mutual funds are then sold to investors, who then can participate in the gains or losses of the investments.  The mutual funds charge some expenses to the investors, covering the costs of maintaining the funds and employing the fund managers.

Q: Alright, sounds reasonable.  Why should I invest in mutual funds, though?

A: The primary reason to invest in mutual funds is for diversification.  Each mutual fund holds dozens, hundreds, or even thousands of individual investments.  Buying shares of a mutual fund allows the investor to own a tiny amount of each of those investments, limiting the damage that a single bad investment choice can cause.

Another advantage of mutual funds is that fund companies will allow you to regularly invest new money into the mutual fund without paying commissions.  This includes reinvesting dividends or capital gains distributions automatically, if you choose to do so.  By investing in mutual funds, you could save the money that would be spent reinvesting these funds in stocks or bonds.

Q: I’m sold.  What types of mutual funds are there?

A: There are thousands of mutual funds, covering just about every investment type in existence.  Just within the stock funds, for example, you have foreign and domestic funds.  The domestic funds are further divided up into growth (companies that are expected to grow faster than most companies), value (stocks that sell for  less than their intrinsic worth), and blend (a mixture of these styles) funds.  And these funds are divided even futher, into large, mid, and small sized company funds, dependent on the overall net worth of the company.  These divisions are expressly shown in a style box, such as the one below, where each small square represents a different type of fund (with some even covering more than one box):

An example style box
An example style box

And there are still other distinctions; some funds invest in particular sectors in the broader market (such as technology or utility stocks), others invest for dividend yield, and still others invest according to principles of social responsibility.  And that’s just domestic stock funds; there are other distinctions for foreign funds and bonds…

Q: Alright, alright, I get it; there are lots of different funds.  Are there any important distinctions?

A: All the distinctions are important.

Q: *Threatening Stare*

A: Alright, one particularly important distinction is the difference between index funds and actively managed funds.  Index funds follow various indexes (like the S&P 500, the Russell 2000, the Wilshire 5000), holding all the stocks in the index (or sometimes a smaller, representative sample).  Actively managed funds have managers running things, choosing which investments to buy and sell.

Q: Ooo, that sounds good.  What could go wrong with having professionals choose my investments?

A: Oh, yes, that… Well, while active management can beat the indexes (in theory), in practice, most actively managed funds keep pace with their respective indexes, at best.  When you take into account the higher expenses charged by active funds (typically above 1% of the assets being managed compared to 0.2-0.4% for index funds), they usually end up lagging behind the comparative index.  A good primer on the difference can be heard on the Vanguard website.

Q: That’s no good.  So, it’s better to stick with index funds?

A: Generally, yes.  While there can be actively managed funds that outperform the appropriate index over a long period of time, it will take time and research to find them.  Furthermore, there will be changes, whether in the management or in the broader economy; active managers that do well in good economic situations may crash during bad times, or vice versa.

For the most part, having most (or all) of your mutual fund money in index funds will serve you well.  Adding actively managed funds only after much research, a thorough understanding of how the fund manager will use your money, and a reasonable expectation of how much more money you will earn from taking an active approach is a smart approach.

Q: I get you.  How should I invest my money in mutual funds, then?

A: That’s the $64,000 question; there are almost as many different ideas of how to invest in funds as there are commentators making the recommendations.  In short, a lot of different ideas are being bounced around.  There are a few generally agreed upon principles:

1) When you are young, you should own mostly stock funds, gradually adding bond funds and even cash to the portfolio as you get older.

2) You should have exposure to foreign markets as well as domestic stocks, to help diversify your holdings even further.

3) Narrower types of funds, such as sector-specific funds, should be used sparingly in your portfolio.  Most of your holding should be broad, total-market  funds, whether in domestic stocks, foreign stocks, or bonds.

I go more in depth about one method of creating a portfolio from stock and bond index funds in my second investment pyramid post.

Q: Any shortcuts to all that investment work?

A: Most fund companies now offer target-date funds.  These are funds of funds, mutual funds that invest in a variety of other mutual funds.  They are designed to start out fairly agressive (mostly stocks) and gradually shift into more bonds and cash as the funds get closer to the target date.  By picking a fund with a target date near the time you intend to retire, you can have an investment that does all the rebalancing and reinvestment work for you over the course of your life.

Target date funds aren’t perfect, though.  They charge additional fees on top of the fees for the underlying mutual funds, increasing the expenses.  They also take a ‘one size fits all’ approach, without regards to individual differences in goals or investment needs.  If you do decide to take this route, do some research, and make sure your chosen target date fund will meet your needs, now and in the future.

That wraps our look at mutual funds in all their glory and splendor.  I hope it helped you to get a feel for this investment and how to take advantage of it.

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