What is a Mutual Fund?

You may have heard the term before: mutual funds. But what is a mutual fund exactly? How do they work? And why should you care?

Mutual Funds, Defined

Mutual funds are called that because they do exactly that: pool money from a wide variety of people into a large, shared (hence the mutual) fund. The money in this fund is then used to invest in a wide variety of investment vehicles.

Great. So what, what does that mean for me?

So glad we pretended you asked! Like any investment, there are benefits and drawbacks to investing in mutual funds. Let’s take a peek at the most important of both, shall we?

Pro: Diversification

In an earlier post I wrote about what it means to diversify an investment. Continuing that, investing in mutual funds gives you more diversity than you might otherwise get if you were investing your money in individual stocks.

Here’s why.

When you want to buy an individual stock, you almost always have to buy in what’s called a lot – that’s a fancy way of saying “quantity of 100.” You can’t just buy a single stock from a company. So if, for example, you wanted to buy stock from a company selling at $100 per share, you’d have to invest at least $100 x 100 shared = $10,000 in that company. Most people don’t have that kind of coin to sink into just one company.

You know who does? Mutual fund managers. Some mutual funds have billions of dollars in assets, which lets them buy a wide variety of stocks and other holdings. As someone who put into the fund, you get to own a little piece of everything the fund owns, which reduces your investment risk.

Pro: Simplicity

Investing in a mutual fund that owns a wide variety of stocks is much easier to manage and track than investing in each of those stocks individually. If you’re someone who likes to carefully track your investments, mutual funds can make a lot of sense.

Pro: Professional Money Management

Mutual fund managers have access to a great many tools and bodies of research that let them make informed decisions on what to buy and sell. While they don’t always get it right, they usually don’t get it wrong as badly as some uninformed individual investors. This is their job, their entire livelihood. You benefit from that

Con: Management Fees

Those professional money managers need to get paid somehow, and who pays them? You do, along with everyone else investing in the fund!

Fund managers are paid a percentage of overall money invested in the fund each year, regardless of how the fund performs. If the fund increases by 10%, and the fund’s annual fee is 2%, you as the investor make 8% on your money. If the fund lost 20%, and the fee is still 2%, then you as the investor would show a decrease of 22% in the value of your assets.

There is a special type of index fund that has lower fees, called an index fund. These funds aren’t actively managed by fund managers, and have lower costs as a result. We’ll cover these investments in more detail in a later post.

Con: You won’t always beat the market

By definition, some mutual fund managers will beat the market average, and some will not. Here’s the kicker though: multiple studies over time have shown that a manager who beats the market one year may just as easily lag it the next year. There is no proven way of predicting the best money managers in a given upcoming year.

Again though, if you know nothing about investing, you could do worse than investing in a mainstream mutual fund recommended to you by your financial advisor. Just one more thing to know about that…

Heads-up: Service Charges

Notice how I didn’t call these section a pro or a con; that’s because it really, really depends. I don’t believe this is nearly as cut-and-dry as a lot of personal finance books make it out to be.

Here’s the thing: most financial advisors will invest your money in (i.e. sell you) a mutual fund on a rear-load basis – that’s an intimidating way of saying that if you try to take your money out too soon after you invest it, you’ll pay a penalty fee.

Here’s why that happens.

For financial advisors who are paid on commission (most of them, in other words), that commission is paid to them by the mutual fund company they’re putting your money into. In exchange for paying the advisor upfront, the mutual fund company needs some sort of guarantee that they’ll be able to collect enough management fees to make that payment worth their while. The rear load (also called a “deferred service charge”) accomplishes this for them.

Now, at first glance this sounds like crap for you as the investor… and in a vacuum, it is. But you’re not investing in a vacuum; you’re investing in real life, where human emotions and urges come into play. It’s all too easy to dip into your retirement savings because you want a new TV, or a trip to Europe. But each time you do that, you’re shooting your future self in the face – not the foot, the freaking face. DON’T DO IT. Not from your retirement fund, at least!

The reality is that a deferred service charge is a good way to force yourself to resist these urges. If you’re going to pay a hefty fee to withdraw your money early, you’re more likely to leave it where it’s supposed to be.

Now if you’re someone who knows enough about investing to handle your own finances, then I personally think it makes no sense to invest in a rear-load mutual fund (I don’t own any, for what it’s worth). But the vast majority of people don’t know enough or aren’t comfortable managing their own finances. For these people, a DSC is a way for them to indirectly compensate their advisor for the work they’re doing to invest their money on their behalf.

If you’re saving for retirement and it’s 7 years or more away, then you shouldn’t have to worry about the penalty anyway. Again, it’s better than putting cash away under your mattress!

Wrapping it Up

This is a simplified overview of mutual funds. They come with a host of advantages over traditional stocks, but a few drawbacks as well. Remember, I’m not a financial advisor – you should always talk to one before making any investment decisions if you’re not sure!

If you want to do some more reading on mutual funds, here are a few other great explanations:

CATEGORY: Investing, Personal Finance

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