Mutual Funds Basics

Mutual funds basics

(Mutual funds: immediate personal recommendation: don’t do them, unless you want to keep your mind off investment and leave it to others, because you can make more money doing it yourself if you know how, then relying on money managers)

Once you've decided to invest in the stock market, mutual funds are an easy way to own stocks in the stock market without worrying about choosing individual stocks. By the way, you can look around and find plenty of information on the Internet and on this website to help you learn about mutual funds and there are many possible avenues for you to study, select, and purchase mutual funds.

What is a mutual fund? It's a single portfolio of stocks, bonds, and/or cash managed by an investment company on behalf of many investors. The investment company is responsible for the management of and looking after the fund, and it sells shares in the fund to individual investors. When you invest in a mutual fund, you become a part owner of a large investment portfolio, along with all the other shareholders of the same fund. When you purchase shares, the fund manager invests your funds, along with the money contributed by the other shareholders. There is a basic idea in this.

The theoretical idea behind a mutual fund is simple: pooling of resources. Many people pool their money in a fund, which invests in various securities. Each investor shares proportionately in the fund's investment returns - the income (dividends or interest) paid on the securities and any capital gains or losses caused by sales of securities the fund holds.

Every mutual fund has a manager who will run and administer the fund, also called an investment adviser or fund manager, who looks around for good securities and the like and directs the fund's investments according to the fund's objective or objectives, such as long-term growth, high current income, or stability of principal. Depending on its objectives, a fund may invest in stocks, bonds, cash investments, or a combination of these financial assets, and may have various policies, and so on and so forth.

Every day, the fund manager counts up the value of all the fund's holdings, figures out how many shares have been purchased by shareholders, and then calculates the Net Asset Value (NAV) of the mutual fund, the price of a single share of the fund on that day. If you want to buy shares, for instance, you just send the manager your money, and they will hereby issue new shares for you at the most recent price. This routine is repeated every day on a never-ending basis, which is why mutual funds are sometimes known as "open-end funds." And if the fund manager is doing a good job of looking around for the best offers in the market, the NAV of the fund will usually get bigger and, voila, your shares will be worth more.

As with any investment, mutual funds come with some caveats, and you should understand those before you hereby invest. Here I list some of the many pitfalls that you may wish to look out for.

There are no guarantees

(US scenario) Mutual funds are regulated by the US Securities and Exchange Commission (SEC), which requires funds to disclose the information an investor needs to make sound decisions. Unlike bank deposits, mutual fund shares are not insured/ guaranteed by the Federal Deposit Insurance Corporation (FDIC) or US government agency. (This means that it is better in that sense to get a CD if one wants security and stability.) In fact, the value of a mutual fund may fluctuate, even if the fund invests in U.S. government securities.

Diversification "penalty"

(Valid for every country) While diversification eliminates the risk of catastrophic loss that would occur if you own a single security whose value plummets, it also limits the potential for making a killing in the market if that security's value shoots up. This is a key idea. Diversification therefore cuts both ways, up and down. It's important to note here that diversification does not actually protect you from a loss caused by an overall decline in financial markets. Diversification is NOT actually protection against loss; it’s a protection against not knowing what you are doing. Know what you are doing and you could wind up richer, rather than not know what you are getting yourself into.

You can possibly make more money doing your own technical or fundamental analysis instead of relying on a mutual fund. Hence there is what is known in economics as opportunity cost. The opportunity costs of participating in a mutual fund are lower profits as opposed to real analytical and fundamental analysis work, which usually pays better and has less fees.

Potentially high costs

Mutual funds can be a lower-cost way to invest when compared with buying individual securities through a broker if you think about it. However, a combination of sales commissions and high operating expenses at some fund companies will actually reduce your investment returns. That means that it is possible to make more money if you do it on your own sometimes. Compare the costs and fees of mutual funds. High costs and fees can badly damage the returns you receive as a shareholder. The point is that while returns may or may not materialise, the costs are certain and sure to accrue.

Be sure to research and read up on mutual funds better, before plunging into any.