Mutual funds are one of the most common investments. They seem to be popular in conversations around retirement and in the personal finance world. For that matter, whenever you watch any news show, it seems there is someone talking about investing or saving money in either insurance or mutual funds.
Mutual funds are one type of investment option that nearly anyone can invest in, but you should never invest in something that you don’t quite understand. In this discussion around Mutual funds, I will hopefully clear up some confusion and offer a better understanding of this powerful investment tool. Let’s take a look at what mutual funds are, how they work, and if investing in mutual funds is right for you.
What is a Mutual Fund?
Mutual funds are large pools of money that are managed by professional investors. They offer access to a lot of different investment opportunities. It can be to be a very inexpensive way to have a portfolio advisor. Typically, anyone can invest into a mutual fund by opening up a brokerage account at a financial institution and depositing money into the mutual fund account. Investment professionals manage the money. They use the cash to invest in multiple companies, which make up the portfolio.
Pool of Investment
It may help to clarify this by imagining 10 people standing around a table and there is a large empty bowl in the middle of the table, everyone then puts $50 dollars into the bowl. The bowl now has $500 dollars. An investment advisor takes the bowl and invests in other companies. The investment advisor takes 5 dollars out of the bowl for their services. The bowl then becomes the investment. When the advisor takes the money and invests in other companies, you do not own the other companies. You simply own one-tenth of the mutual fund.
Now, if the companies that make up the mutual fund go up, then you gain appreciation on your mutual fund. However, if they go down, you lose money on your investment. It’s important to understand that when investing in mutual funds, you do not own any of the underlying companies.
Types of Mutual Funds
Since the the money is invested in other companies, it’s important to know what those investments can be. The type of fund will tell you what it invests in. This can be company stock, company bonds, commodities, real estate, and the list can go on. If they invest in large companies in the U.S., they would be considered a Large US Stock fund. Likewise, if they invest in only company bonds, they would be considered a Taxable Bond fund.
Inside a typical stock mutual fund are stocks from dozens, sometimes hundreds, of different companies. When you put money in a mutual fund, you’re effectively buying into all of those companies. As I mentioned earlier, you may make money on your investment if the underlying stock of that company goes up, conversely if their stock goes down, you may lose money. Typically, the benefit of investing in these is that not every single company will go down at the same time. Some go up and some go down, the net of this is your return. This concept of spreading your risk by investing in mutual funds is often call diversification.
Inside a typical bond fund, there are investments in bonds from various companies. A bond is debt obligation that a company must pay an interest rate on. When you hold a bond from a company, you offered the company a loan that they pay back. When a mutual fund company uses your money and invests in a bond fund, the mutual fund is loaning the money to the company for you. However, you benefit from the value and interest rate increase associated with all the bonds in the fund. The concept is still the same as a stock fund, the difference is simply debt versus equity financing.
Since a mutual fund is effectively a pool of cash that is used for investment, it can invest in anything, as long as it meets the criteria of a fund. Real estate funds seek to gain value by investing in various real estate ventures, this could be commercial or residential. Commodities funds seek to benefit from the rise of the commodities exchange. Their underlying assets could be sugar, gold, cotton and many more. Government bond funds or treasury funds seek to invest in the government of the U.S. or other countries.
Are Mutual Funds Right for You?
Investing in Mutual funds is typically very easy. One advantage is the initial cost. There are so many funds that have a $0 dollar minimum to invest. I know that Charles Schwab offers many low investment funds. Another key advantage of investing in mutual funds that was mentioned above is diversification. You may have heard of the phrase, “Don’t keep all your eggs in one basket”. They were created with this concept in mind. I would encourage you to read, ‘The Little Book on Common Sense Investing’ if you have some time. John C. Bogle is the author and he discusses index funds and diversification in some detail. Read this book if you would like to take your mutual fund knowledge to the next level.
Automate your Investment
Furthermore, investing in mutual funds can be automated. There is usually an automatic investment option where you can make a monthly transfer into the fund directly from your paycheck and which makes it harder to spend the money before you invest it. More on automated investing my post Savings and Investing. The key here is that automatically investing in stand alone company stocks usually not an option provided by the financial institution.
Picking Stocks can be Hard
Mutual funds offer the diversification of multiple companies. If you enjoy picking individual stocks or any type of active trading, then they are not the correct investment vehicle. Mutual funds take out a lot of the guess work of picking individual stocks. Given that there are thousands of companies out there on the stock exchange, how do you begin to invest in individual stocks? Bottom line, research is required in picking individual stocks. Plus, you must actively monitor the investment. Investing in mutual funds allow other people to do a lot of the guess work.
Mutual funds are very common investment options. They can be a great way to spread your money over different companies and thereby reducing some of your investment risk. Mutual funds can also be a very easy way to invest in the potential gains associated with the stock market. Most mutual funds offer an automatic investing process so that is a very easy way to save automatically.
If you like the idea of putting your money somewhere, which on average earns more interest than a savings account, then mutual funds could be right for you. In addition, they could be right if you don’t want to do research on individual stocks. Moreover, if you don’t want to be exposed to one sector of the financial market, and prefer to not put all your eggs in one basket, then mutual funds might be a good option for you. There are so many factors to consider when looking at the correct fund to invest in. In general, they are safer than individual stocks and can offer investment growth.
As always, please seek advice from a financial advisor before making any changes associated with investments. I really hope you enjoyed this post and learned a little bit regarding mutual funds.
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