The Basics: Investing in Mutual Funds

In Part 1 of our back-to-basics course, we looked at savings bonds. Next, we’ll tackle another easy one: mutual funds.

Investing terms can be confusing, but that’s not really the case with mutual funds. They are what they say they are. A mutual fund is a company that brings together a group of people (mutual) and invests their money in stocks, bonds, and other securities (fund). Each investor owns a share of the fund, as opposed to a portion of the stocks that make up the fund. The “shares” of a mutual fund represent a portion of the overall holdings of the fund.

Many mutual funds are more or less pre-diversified, because they invest in stocks and bonds in many industries and many different locations, although there are some funds that focus on particular sectors, such as healthcare or technology. Mutual funds are popular with investors because they don’t require a lot of time and effort to keep track of, and they don’t necessarily involve a huge up-front investment. Buying 1,000 shares of Apple stock may be a great idea, but it’s a little pricey, and it offers no diversification.

Mutual funds have other advantages as well, including economies of scale, very high liquidity, and professional management. Purchasing power is better than for the individual investor, constant trading allows for easy entry and exit, and a professional money manager is making the fund’s investing decisions on your behalf.

Is there a downside? Of course there is!

So how can this go wrong? This is investing, so it can go wrong. That professional money manager may be very good—or not so good. And he or she comes at a price as well. Mutual funds always have fees, which typically include both shareholder fees charged when you buy or sell shares of the fund, and annual operating costs (typically around 1-3%). Because these fees aren’t waived if the fund loses money, any losses an investor experiences are magnified.

The liquidity of mutual funds is great, but since investors are constantly buying into and selling out of the fund, the company that manages the fund keeps large amounts of cash on hand—cash that is not earning much of a return. And if the fund is dissolved due to losses, your investment is not protected by the Federal Deposit Insurance Corporation.

While mutual funds are regulated by the Securities and Exchange Commission (SEC), it can be difficult to decipher exactly how much the fund is investing in what it says it’s invested in. The SEC requires that 80% of a fund’s assets are invested in the particular type of investment listed in their names (eg., “international growth fund,”), but those definitions can be a little vague, and how is that other 20% invested? Unlike individual stocks, for which price-earnings ratio information and other investment measurable are easily obtained, performance information for mutual funds may be difficult to compare to other funds.

Knowledge Is Power

As with all investments, before purchasing shares of a mutual fund, do your research. While you don’t have to study the potential returns of individual stocks and bonds, you do have to take a close look at the company offering the fund: What are their investment goals? How has the fund you plan to purchase, and the company offering the fund, performed in the past? (As usual, past performance does not guarantee future results.) Find out how diversified the fund is, and what fees you’ll likely face for your investment.

For certain investors, the advantages of mutual funds will outweigh the disadvantages. Finding out if you’re that kind of investor, and if there is a fund that matches well with your financial goals, requires due diligence.