Investing 101: Intro to Mutual Funds

So, you’re ready to start investing: You’ve read up on stocks and bonds, and you’re anxious to put your money to work for you. The only question now is this: Which stock will you buy first?

If you don’t have a good answer to that question, fear not. You’re not alone. Although everybody knows that we can make good returns on our money by investing well, very few of us really know which companies we should buy shares in. After all, there are more than 9,000 stocks on the market in the U.S. alone, and that doesn’t include other investment vehicles like bonds, commodities and other securities. Unless you have a lot of spare time on your hands and are a very fast learner, your chances of correctly picking a stock to invest your nest egg in are little better than correctly picking the winner of a horse race.

Enter the amateur investor’s best friend — mutual funds. These special investment plans make the stock market accessible to ordinary people, and usually represent your best strategy for investing for the future.

The idea behind mutual funds is this: You probably don’t know a whole lot about the stock market, and don’t have a clue about where to begin investing your money. But there are people out there (especially on Wall Street) who are very well educated on the stock market, and have proven that they can win with investing. So you entrust to then the money that you want to invest, and let them buy and sell stocks for you. In exchange for handling your investments for you, your manager will charge you a small annual fee, or perhaps a small commission on any gains you make.

Now, that manager isn’t going to make much profit if he only handles your money. So in addition to your funds, he accepts investment money from thousands and thousands of other people, and invests all of that money in the exact same way that he invests yours. In the end, he has created an investment fund owned by many different people. Because it’s a shared endeavor, we call it a “mutual fund.” Each investor owns a very tiny piece of that fund; the fund, in turn, owns millions of shares in hundreds or thousands of companies. When the fund makes money, all of the individual investors make money. When the fund loses money, everyone shares in the loss.

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The vast majority of retirement investment in America is done through mutual funds. If you participate in a 401(k), IRA or similar retirement plan at work, you’re almost certainly investing that money in mutual funds. But you don’t have to go through your employer to have access to these funds. There are hundreds of mutual funds on the market, and most of them are available to individual investors. You can get involved with many mutual funds by dealing directly with the companies that offer them, often via their websites.

What are the benefits of mutual funds? There are many. First and foremost, you get the benefit of professional guidance. Most mutual funds are run by teams of investment experts who spend their full careers analyzing the tiniest details of the companies that they invest in. They know exactly what to look for, and work at a level of expertise that you and I can never hope to match individually. When you invest in a mutual fund, you get the full benefit of their expertise for a very reasonable price.

Secondly, mutual funds offer built-in diversification. Investing all of your money in one company is never a good idea, because if that company falters, you can lose all that you have. (The Bible even teaches us about the importance of diversification — Eccl. 11:2 says “Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.”) Since most mutual funds own hundreds or even thousands of stocks, you’re well protected against the prospect of one or two companies failing.

Another great benefit of mutual funds is that it’s relatively easy to pick a fund that meets your needs. Most funds are designed to fulfill specific investment objectives, or to invest in certain business sectors or geographical regions. If you’re willing to take on a lot of risk, you can choose funds that focus on companies that are growing rapidly (or “aggressive growth” funds). If you’re trying to minimize your potential for losses, you can choose mutual funds that invest heavily in bonds or very stable stocks. You can choose funds that focus on technology stocks, medical stocks, or companies based in Asia, South America or Europe. You can even choose to distribute your investments across various mutual funds, to see to it that your portfolio is extremely diverse. And every mutual fund offers a very clear and transparent track record, so you can see exactly how successful those manager have been in the past.

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Finally, mutual funds offer you access to great investment deals that you won’t get as an individual. Since many mutual funds represent massive amounts of money, the have massive buying power, and can buy stocks at discounted prices. Sometimes mutual funds get first crack at attractive new stock offerings. And you also save a lot of money on trade fees — if you bought all of the stocks in a mutual fund as an individual, you would pay a fortune in fees to your broker. Mutual funds work in such high volumes that the fees to each user are almost negligible.

I hope I’ve explained just how beneficial mutual funds are. You may have some success investing in individual stocks or bonds on your own, and if that kind of thing interests you, I would encourage you to explore it with small amounts of money. But don’t be surprised when mutual funds outperform your individual investing endeavors. They almost always do.

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Photo by Particlem. Used under Creative Commons License.

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