Mutual funds 101

Even though this is about mutual funds, let’s start with the very basic investment: a share of stock. When you own a share of a stock, you own a little piece of one company. You can sell your share at any time – tomorrow or 50 years from now. The price of your share when you sell it will be based on whatever other people are willing to pay for it.

If that company does well and makes money, the value of your share usually increases. But if the company loses money, the price of your share generally goes down because people don’t want to take a chance on losing money in the company.

To smooth out those ups and down and help mitigate large losses, you want to diversify.¹ While there is no guarantee that any share will increase in value depending on market performance, you will want to buy shares of many companies. A properly balanced portfolio helps in preventing a scenario where downturns could have a bigger impact. Even if one company goes bankrupt, your money is spread out across many other companies. The loss of that one company may even be negated by the performance of some of your other companies.

The problem here is that to be properly diversified you’ll need more money than the average small investor has. And you have to actively manage your shares in all of these companies, knowing when to buy more of one or sell all of your shares in another. That takes a great level of skill, experience, knowledge, and resources.

An investment portfolio in one little share

A mutual fund may solve many of your investing dilemmas. Each share represents a diversified collection of investments that can include stocks, bonds, real estate, cash and other financial assets, all managed by a professional investment specialist. The fund can afford to buy all of these assets and hire experienced management because many other small investors like you have pooled their money together and purchased shares in the mutual fund.

To buy into some mutual funds requires an investment of only a few hundred dollars. Most however, require a minimum investment of several thousand dollars. The minimum investment may be lower if you are opening an IRA account.

How can you tell the value of a mutual fund if it owns many investments?

The Net Asset Value (NAV) is the indicator of the value of the fund and also helps determine at which price shares could be bought or sold at, not including additional sales commissions. The NAV is the total value of all the securities held by the fund divided by the number of shares of the fund. As an example, Mutual Fund X holds securities (stocks, bonds, cash, etc.) worth $1 million today. Fund X has sold a total of 10,000 shares. The NAV of Fund X is $1 million/10,000 shares or $100 today.

How can a mutual fund make money for me?

The value of any mutual fund will fluctuate, meaning its price goes up and down. How much it goes up and down is called volatility. In most cases, your strategy for making money is to minimize volatility and maximize returns.

On the other hand, it is also important to know the combined costs of running a fund which is called the expense ratio. It is the percentage of costs compared to the overall fund price. You, as a fund investor, have to pay your share of the costs which includes: the salary and expenses of the fund manager and staff and their overhead (even if the fund is losing money) which are called management fees. You also pay the transaction costs (buying and selling the investments), distribution fees and other expenses of the fund. If you are buying load funds you have to pay commissions to dealers and agents.

Passive investments can reduce your costs

A mutual fund run by a fund manager who makes the investment decisions is called an actively managed fund. To avoid the costs associated with that approach, look to index funds, which are a collection of stocks (or other investments) modeled on a well-known index, such as S&P 500. Since this type of mutual fund is designed to mirror the performance of the index, it is made up of the same stocks in the same amounts as the index itself. There is no buying or selling or trading (unless the index itself makes changes to its mix). So these passive investments, usually have lower expense ratios then active managed funds.

¹ Using diversification as part of your investment strategy neither assures nor guarantees better performance and cannot protect against loss in declining markets.