An Introduction to Mutual Funds

What is a mutual fund? A way to reduce costs, diversify our holdings, and save time when we invest.

 

By: Robert F. Abbott, freelance writer and author of Big Macs & Our Pensions

We’ll examine these and other key mutual fund benefits in more detail later, but let’s begin with a simple analogy: Suppose you decide to save for education or retirement by buying a piece of property, perhaps with a house on it, perhaps without. Perhaps it’s a revenue property, with renters, or perhaps not.

what is a mutual fund

Lots of decisions, right? But, with the help of a realtor, you look at a dozen houses, and then make a decision based on criteria such as location, potential appreciation, revenue, if any, and the cost of upkeep.

As you looked at those properties, you might have wished you could own a piece of half a dozen of the best, rather than having to choose just one. If you could spread your investment around, you’d sleep better at night knowing you had a diversified portfolio of properties. Diversification means you don’t bear the entire risk if something happens to the property you selected, if an outlaw motorcycle club moves in across the street for example.

And, assuming you’re buying pieces of half a dozen properties, rather than putting all your money into just one, you’d likely invest with a group of friends or at least with people who shared similar goals. Because your group is collectively buying six homes, you could negotiate a much better deal with the realtor, bring your transaction costs down substantially.

Now, let’s substitute stocks for properties. Instead of buying 100 shares of Apple and hoping for the best, you get together with a half dozen other people in your situation and buy a number of stocks. Again, you reduce your risks by owning a basket of stocks rather than just one, and you reduce your transaction costs. That’s essentially what happens when you get involved with a mutual fund.

If we ask again, “What is a mutual fund?”, we’d also want to discuss tangibility. A house you bought for income or to help fund your retirement is a tangible thing (something that becomes all too obvious when you get called in to fix the overflowing kitchen sink). A share in a mutual fund, though, is intangible. You don’t even receive a piece of paper like a share certificate. But otherwise, being a mutual fund investor is much the same as sharing in the purchase and ownership of a number of real estate properties, rather than committing everything to just one property.

There’s a parallel we might explore at this point, a parallel which will help us fully deal with the question, “What is a mutual fund?” That parallel has to do with insurance. Today, with at least hundreds of brokers and insurers fighting to cover our cars and homes, it’s easy to take insurance for granted.

But, a couple of hundred years ago, insurance of any kind was rare. But, it did emerge, at least in its current form, when groups of newly prosperous people got together to share risks. For example, most giant life insurance companies began when small groups of individuals began contributing to small funds in the seventeenth, eighteenth, and nineteenth centuries. Because the individuals created their own pools of funds, and were the owners as well the policyholders, these entities became known as mutual insurance groups.

The parallel, of course, is that individuals contribute together, and profit or share losses together. We see initiatives based on the mutual sharing of risks and the mutual sharing of rewards or losses. Today’s credit unions operate on similar basis+ADs- each individual who wants to save or borrow must first become a member and buy a share or shares.

If we were to ask the question again, “What is a mutual fund?” we might now say a mutual fund is a vehicle in which individuals get together to pool their resources. With that pooling — or mutualization –comes the expectation they can reduce their individual risks by diversification and reduce their transaction costs. As we’ll see in the articles that follow, good diversification and reduced transaction costs can make a very big difference in investment returns.

But, before doing that, let’s also note it’s no longer necessary to get together with your friends or family, as our ancestors did a few centuries ago. Depending on where you live and invest, you will likely have hundreds of existing mutual funds from which to choose. The modern challenge is not to find others with whom to mutually invest, but to narrow down the immense field of firms ready and waiting for us.

And, if that wasn’t enough, mutual fund investors now can buy Exchange Traded Funds (ETFs), which are similar to mutual funds in some ways.

A mutual fund provides an investment option for those of us who cannot afford to hire professional money managers or services.

It would be prohibitively expensive, in terms of both time and money, for most of us to invest on our own. We face the costs of professional research, brokerage fees whenever we would buy and sell stocks or bonds, and more. By pooling our money and our goal of creating new wealth for the future, we can get dip our toes into the oceans of investment without worrying about drowning.

Next, we should ask, what are mutual funds in less abstract terms. In that case, mutual funds are individual groupings of stocks, bonds, cash, or some combination of these three. Most mutual fund companies have a range of funds, to provide their investors with choices.

Behind most classifications of mutual funds lies what might be called a risk profile. How likely is it I will lose money if I invest in this fund? Very conservative funds generally invest in just money market funds — they’re not likely to lose you any money or sleep, but they won’t make you much richer either. Turning 180 degrees, we find stock, or equity, funds. These invest solely in stocks of corporations, and carry more risk. But, they also have greater potential for high returns. So, you’ll always have to face tradeoffs, between potential risks and potential rewards.

Now, what are mutual funds in terms of getting something back, when we need or want the money. Ideally, you’ll get more back than you put in, although that is rarely guaranteed. With most funds, you’ll earn interest (rent for the use of your money), dividends (sharing in a corporation’s profits), capital gains (sharing in the proceeds when shares are sold for more than they cost), or some combination of these.

What is a mutual fund? Well, I hope this article has helped you develop a better understanding by giving you analogies, history, and parallels. Grasp the essence of the idea of mutual and you will be able to approach mutual fund investing more confidently and more successfully.

Next, read about the Downsides of Mutual Funds

Mutual Fund Fact 1: In 2013, Americans owned $15-trillion worth of mutual funds (2014 Investment Company Fact Book)

The Writer

Robert F. Abbotttop mutual funds is a freelance writer; see his profiles and analyses of value stocks at GuruFocus.com . He is also the author of Big Macs & Our Pensions: Who Gets McDonald’s Profits?

In this book, you will:

  • Discover the Ownership Revolution, and what it means to your retirement funding.
  • Find out how much of your lunch bill is a profit for McDonald’s, and who gets the profits.
  • Learn how corporate profits fuel one of the greatest social programs ever developed.

Click here to read a free preview at Amazon.com