The Basics of the Mutual Fund

Mutual Fund Basics

Mutual Fund Basics

If you have a company 401K, then you probably invest into a mutual fund versus investing in individual stocks.

But do you really know what it is?

Let’s cover some mutual fund basics.

A mutual fund is an investment company that pools the money from several different people (investors like you) and then buys into stocks, bonds, money market accounts, or other assets, like commodities. Shares of this company are then offered for sale.

Mutual funds therefore have to be managed by a fund manager, who collects all this money and makes sure to buy and sell all the right stocks, bonds, etc.

One thing I learned recently when studying mutual fund basics is that these funds can make money for you in three different ways: dividend payments (from the stocks owned within), capital gains (when stocks are sold within the fund), and increased net asset value (NAV).

When I typically think about mutual funds, I just think in terms of increased NAV. I forget that some stocks pay dividends, and that managers are constantly selling winning stocks to lock in gains. I guess because these gains and dividends remain in the fund, you don’t really think about it.

Why Invest in Mutual Funds

There are several reasons to like mutual funds. Mutual funds allow the beginning investor to own a diverse set of stocks, bonds, etc. without having to use large amounts of money to buy into each asset class or stock. Instant asset allocation.

For instance, with the American Funds Mutual Fund (AMRMX), you can pay $250 and get several shares. In each share of this fund, you’ll be buying into U.S. stocks, fixed income, cash, and international stocks. And within your stock purchase, you’ll own pieces of Merck, AT&T, Microsoft, IBM, and many, many others.

To get this kind of diversity with your own money, you’d need a heck of a lot more than $250 (the fund minimum). And you’d need a lot of time on your hands. Mutual funds don’t just sit around on the same mix of investments. They are constantly moving in and out of different stocks and bonds to try to maintain a good performance and to hold true to the fund’s original goals.

So with a mutual fund, you get a full time professional manager to handle all of this. The trade off with mutual funds is, of course, that you have to pay this professional to manage all this for you. James Dunton has been managing the AMRMX fund for 39 years. I’m sure he’s paid well for his services.

Risk Involved with Mutual Funds

The risks involved with mutual funds are the same with any other security investment. The investment can lose value. There is also the risk of too many expenses. Mutual funds are often heavily managed. Therefore they come with a cost. When these costs are too high, and your investment return is too low, you could be losing money.

Different Types of Mutual Funds

The three main types of funds are money market funds, bond funds, and stock funds. Money market mutual funds generally try to preserve value. This is considered the safe haven in most portfolios.

Although, as we’ve discussed before, they are not FDIC insured like a money market account. Bond funds are more risky fund, and they aim for a low return. Stock funds are the most popular and diverse mutual fund category. They come in all shapes and sizes.

Four common examples of stock funds are: growth funds, income funds (dividend stocks), index funds, and sector funds. Another hybrid type of mutual fund is the target-date fund, which invests in cash, bonds, and stock, getting more conservative as I age.

I currently use the Vanguard 2040 fund. What type of stock funds do you own in your 401K?

Mutual Fund Expenses

The fees break down into two basic categories: shareholder fees and annual fund operation expenses. The former are usually charged when you buy or sell. The latter are charged on an annual basis just for holding the funds.

When funds are described as no-load, they are referring to the shareholder fees. When you compare “expense ratio” know that they are referring to total annual fund operation expenses. Fund companies don’t make it easy to locate the expenses and fees associated with funds, so be prepared to research this before buying into a fund.

How to Invest in Mutual Funds

Mutual funds can be purchased at a mutual fund company directly like at Vanguard or Fidelity. They can also be purchased at a stock broker, a bank, or even with a CFP.

Last Edited: February 16, 2012 @ 1:59 amThe content of ptmoney.com is for general information purposes only and does not constitute professional advice. Visitors to ptmoney.com should not act upon the content or information without first seeking appropriate professional advice. In accordance with the latest FTC guidelines, we declare that we have a financial relationship with every company mentioned on this site.
About Philip Taylor

Philip Taylor, aka "PT", is a CPA, financial writer, FinCon CEO, and husband and father of three. He created PT Money back in 2007 to share his thoughts on money and to meet others passionate about managing their finances. All the content on this blog is original, and created or edited by PT. Read more about Philip Taylor, and be sure to connect with him on Twitter, Facebook, or view the Philip Taylor+ Google profile.

Comments

  1. I need to do something with an IRA. Do you like the Vanguard 2040?

  2. I like Vanguard by default because they are typically the least expensive. To a degree, all target date funds mirror each other, so I try to control the one thing I can: expense. When I have more time and can make for sophisticated decisions, I will probably move back into individual mutual funds and index funds. But for now I’m content letting the TDF do the work.