What are Mutual Funds and How Do I Invest in Them?



What holds you back from investing? Is it stocks? Do they scare you to death? If they do, I really don’t blame you. All the “ifs” in the beginning can be overwhelming! Which ones do I pick? Where will I find the right stock metrics and information to tell me? Why do they keep bouncing around in price? How long until I have a heart-attack?

Would you prefer a way to “stick your toe in the water” and not have to deal with such wild fluctuations? If so, then let me introduce you to the world of mutual funds. “What are mutual funds” you ask? Well, for starters, they are where I started when I first invested – long before I ever bought my first shares of individual stock. But even today, after everything else I’ve learned, mutual funds still play a very important role in my investment strategy. Here is your introduction into the world of mutual funds …

What are Mutual Funds?

Rather than give you the boring text-book answer to what are mutual funds, I’m going to illustrate it! To begin, let’s pretend we’re going to buy some stocks and we want to look closely at our risk.

Consider what happens if you buy one stock.

You could get lucky and it might go up. Or you could be really unlucky and watch it go all the way down to $0!! Ouch! I wouldn’t put my whole retirement account here! Too much risk!!!

So let’s instead buy five stocks.

This a little better. Maybe one or two of them will do good, and we’ll make a little money. On the down-side, perhaps one of two of them will do really poorly. But that’s okay because the good and bad have better chances of averaging out. But we still have the possibility that all five could go to $0! So we’re not exactly bullet-proof yet. Keep going ….

Now let’s buy five-hundred different stocks!

All right!! Even though the whole market may cycle up and down, our chances of going broke have been dramatically reduced!

But wait! I can’t afford five-hundred different stocks! At $7.95 per share from ShareBuilder, that’s $7.95 x 500 = $3,975 in stock commissions!! I don’t want to pay that!

Okay, so what if we get a few friends to help out? Let’s get you, me, and a few thousand other people to pool our money together in such a way that the commission costs are basically negligible.

In a nut-shell, this pooling of money to create a basket of investments is what mutual funds are!

Mutual Funds are Virtually Any Combination of Investments:

Don’t take my overly simple example too literally. Mutual funds don’t necessarily have to be just stocks. A mutual fund can be virtually any number and any combination of investments:

• Stocks (value, growth, large, small, domestic, foreign, etc)

• Bonds (government, corporate, junk, municipal, etc)

• Cash (CD’s, money market, etc)

• Real estate

• Even other mutual funds!

• And a lot more ….

The exact number of things in our “basket” is different and often changing all the time. Most people who own mutual funds have little knowledge of the details of what is specifically inside them. More often, you the investor is more focused on the goals of the mutual funds.

The Goal of Mutual Funds:

Why are there so many combinations of mutual funds out there? Because each one has a specific goal for a specific type of investor:

• To make a lot of money (but take on more risk). For example, you could buy mutual funds that invest heavy in foreign stocks or real estate. Will it make you a lot of money? Maybe. Could you also lose a lot of money. Probably!

• To be ultra-safe (but possibly not return as much money). For example, you could buy mutual funds that invest in the safety of government bonds. Will you get rich? Probably not very quickly. But will you lose all your money? Not very likely!

• And everything in between ….

One of the biggest criticisms of mutual funds are that they move too slow. Most lack the sexy allure of making ten times your money in one year like some hot, unknown tech stock!

But at the same time, you rarely hear people complaining about how much money they’ve lost in a mutual fund. It’s pretty rare to lose 90% of your investment like you could at any given minute with some ill-chosen stock pick.

So even though they may not rock the boat the way individual stocks might, mutual funds still have to be selected with great care.

What to Look for in Mutual Funds:

There are always two main things to look for in mutual funds:

1. Performance: We all want to make more money, right? Isn’t this the reason we invest? So to do so, you need to find a fund that has a great record of performance (i.e. hasn’t lost a lot of money over the years). Please read my post How to Pick Good Mutual Funds for Your 401k or Retirement Plan and replace the word 401k with IRA, 403b, or even just your brokerage account. The principles will still be the same. Please note – past performance will never tell you how much you’re going to make in the future, but it can help you avoid losers!

2. Expenses: Going back to my example above with trying to buy 500 stocks, mutual funds have to cost something because there will always be some costs associated with acquiring the stocks, bonds, etc and then selling them. Some mutual funds will even have to pay a manager to make decisions about what investments it is going to have (called active funds). Others will simply follow a known bench-mark or index (a group of stocks that people already pay attention to) like the S&P 500 or Dow, and will not be actively managed (called passive funds). Overall, you want your fees to be as low as possible, and they can be reduced down to the following three categories …

What Do I Have to Pay for Mutual Funds and Where Do I Find Them?

To keep things very simple, here is a brief summary of the different types of expenses that come with owning mutual funds and your strategy for keeping them as low as possible:

1. Taxes. We all know that we have to pay taxes on most things. Taxes on mutual funds are only avoidable if you are using a retirement account to buy them. For example, if you buy mutual funds through a 401k, 403b, traditional IRA or something similar, then you won’t pay any taxes until you retire. My advice – Even though you’ll pay taxes on them now, I suggest buying your mutual funds through a Roth IRA because of the advantages later on in life. Usually when you go to buy them, the broker will give you the option of buying them for an IRA or just as a regular-old taxed investment account. I’d start with Vanguard.

2. Loads. The word “Load” means “fee”. If you ever hear the words “front load” or “back load”, run for the hills! Back when mutual funds first came out, it was pretty common to see these extra one-time fees associated with a mutual fund. But times are different and you can do better! Today, you want a “no-load fund” (meaning no fees) and there are plenty of good ones out there. My advice – again, try Vanguard or Fidelity. Vanguard is known for having mostly no-load funds that perform just as good (or better) than the more expensive “load” funds.

3. Expense ratio. An expense ratio is a fee you pay (expressed as a percentage) every year for the management of the fund. This one is unavoidable, but manageable. For the reason I presented above, you will always have to pay something for the convenience of owning this group of investments. But you don’t have to break the bank! My advice – seek great performing funds with the lowest ratios possible! One more time – try Vanguard or Fidelity for some cheap mutual funds. How cheap is cheap? I would try to keep it under 1%. Keeping it under 0.5% would be even better! How are you going to do that? Keep reading …

What Are Mutual Funds I Should Start With?

Okay, after all that, you’re probably looking for my suggestion as to which mutual funds are good. And of course – BIG DISCLAMINER – I’m just a regular guy who is NOT a financial advisor, so you really shouldn’t take my advice. But since you ask, here’s my humble opinion:

• The easiest of the mutual funds to follow is the Vanguard 500 Index Fund Investor Shares (symbol VFINX). All this no-load mutual fund does is follow the S&P 500 Index which are the top 500 stocks. Every day when you watch the news and they report on the S&P 500, you’ll know if you went up or down. It takes a minimum investment of $3,000 to get started and has an expense ratio of 0.17% (or $17 for every $10,000 you invest). Plus, there are many people who believe in using this specific Index because it has a long history of returning an annualized rate of 8% per year over the long haul. Not bad for $17!  For steps on how to actually buy this fund, read my post How to Buy an Index Fund.

• One of the first mutual funds I ever got into and still hold (for my kids) is the Vanguard STAR Fund (symbol VGSTX). This is another no-load mutual fund that basically invests in 11 other mutual funds and tries to obtain a 60% stock, 40% bond portfolio (another holy grail combination for investors). The beauty of this one is that it only takes a minimum investment of $1,000 to get started! Perfect for anyone who either doesn’t have a lot of money or just wants to get their feet wet. Also, it has a very low expense ratio of 0.34% (or $34 for every $10,000 you invest).

But just so we’re on the same page, let’s review that disclaimer one more time: I’m not a financial advisor, so please proceed at your own risk!

Suggested Reading for Getting Started with Mutual Funds:

It was several years ago in college. I was clueless about investing. But I was hungry for knowledge. I knew it was time to move beyond savings accounts and CD’s and learn exactly what mutual funds are. I received the book Mutual Funds For Dummies and from there the race was on. The book was completely comprehensive and it wasn’t long before I bought my first mutual fund (the Star Fund above). If you’re looking for a place to start, then let me suggest you start here.

Readers – What other questions do you have about mutual funds? Do you already have experiences with them that would be valuable for others to know?

 

Related Posts:

1) Six Easy Steps to Figuring Out Your Retirement

2) How to Pick Good Mutual Funds for Your 401k or Retirement Plan

3) How to Buy an Index Fund

Photo Credits: Microsoft Clip Art, MMD

Comments

    • MMD says

      Individual stocks are okay if you have the time and gut to do things right. Mutual funds can still be a very important part of any portfolio as long as you choose some low cost alternatives. There are some days when I wish my stock picks gave me the 8% Index Fund return.

  1. Justin @ The Family Finances says

    You did a good job here of laying it all out nice and simple. I have mutual funds in my 401k and made sure to choose funds with low fees. The vanguard 500 index fund holds the bulk of my balances.
    Justin @ The Family Finances recently posted..Backup Duties At WorkMy Profile

    • MMD says

      Thanks Justin! Good move picking the low cost funds for your 401k. I wish Vanguard funds were an option for mine.

    • MMD says

      Is it just one mutual fund or a few? They do tend to fluctuate, which is normal. I can ride those waves easier than I can the ones for individual stocks.

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