Investing 101: 3 Things You Should Know About Mutual Funds

The following post was originally published on Debt Free Guys

This is our second post our Investing 101 series.  See the whole series here. As 51 percent of Americans didn’t save for retirement in 2014, they unfortunately have so far missed out on the fourth longest bull market run in history. The most common reason survey respondents gave for not investing was they didn’t know enough about investing to invest. With this series, we hope to demystify investing.

Last week we discussed individual stocks, both common and preferred stocks. This week, we’ll discuss mutual funds. Next week we’ll discuss exchange traded funds or ETFs.

1. What are Mutual Funds?

Mutual Funds are a basket of investments pooled together to create a unique investment product.

Mutual funds may be comprised of other investments, such as stocks, bonds, treasuries, annuities, cash, and more. The types of investments that can be held in mutual funds are unlimited.

Mutual funds are like little businesses. Managing the allocation of mutual fund investments to meet the mutual fund’s investment objective requires a mutual fund manager, support staff, marketing, research and development and more that require money. To fund this business, mutual funds charge an “annual operation expense” from their mutual fund investors.

2. What Types of Mutual Funds Are There?

A stock mutual fund holds many different stocks. Often certain stocks are pooled together to create a specified investment objective for the mutual fund. For example, a “large capital mutual fund” is mostly comprised of stocks of companies with which you’re likely familiar, such as Apple, Exxon Mobile and Wal-Mart. An “emerging market mutual fund” may be comprised of stocks in companies from lesser developed nations, such as Taiwan, Brazil and Uganda.

For any segment of the world economy in which you may want to invest or any investment objective you personally have, there is a mutual fund for it.

The most prolific types of mutual funds are index funds, which track standard market indices, such as the S&P 500 for large capitalization stocks or the Russell 2000 for small capitalization. There are other indices and there are mutual funds that track them.

Your best resource for learning about a mutual fund’s investment objective, expenses and other details is the mutual fund’s prospectus. This can be requested from your stock broker, accessed online or requested from the mutual fund company. A good rule of thumb is to never invest in a mutual fund without first fully understanding all its nuances.

3. What Are the Rewards and Risks of Owning a Mutual Fund?

The main risk with owning mutual funds, as currently highlighted by the Lockheed Martin settlement last week, is that many mutual funds have very high annual operating expenses. It is believed that many times these expenses are higher than they should be, relative to comparable funds (similar investments and performance) with lower expenses.

The lowest cost mutual funds are typically index mutual funds. That is because these funds track a pre-existing index. Managers for these funds mostly buy and sell investments similar to the investments that comprise the indices.

For mutual funds that don’t track an index, called actively managed funds, fund managers and their staff must make investment decisions based on the mutual fund’s stated investment objective. This can be a very complicated process, which justifies a higher fee than that of index mutual funds.

Passive mutual funds frequently beat the more expensive actively managed funds. For example, according to a Goldman Sachs’ study, 85 percent of actively managed large cap funds are trailing the S&P 500 Index year-to-date in 2014. There’s not much time left for actively managed mutual fund managers to turn things around.

Ironically, the rewards of owning a mutual fund are that they provide an investment manager for those not well versed in investing or without the time to pay close attention to their investments. An additional benefit is that with just a few different mutual funds with difference investment objectives, an investor can be well diversified. Diversification reduces investment risk and exposes an investor to more of the benefits of investing.

That’s what you need to know about mutual funds. With this basic understanding of stocks and mutual funds, you now have considerable knowledge about the most popular and prolific investment types.

Next week, we’ll discuss exchange traded funds (ETFs).

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