What’s stopping you from investing? Is it stocks? Do they terrify you? If they do, I totally get it. All the uncertainty at the beginning can be daunting! Which stocks should you choose? Where do you find reliable metrics and information? Why do their prices keep fluctuating? When will the stress give you a heart attack?
If you’re looking for a way to dip your toes into the investment world without dealing with such wild swings, let me introduce you to mutual funds. You might be wondering, “What are mutual funds?” Well, they were my starting point when I began investing—long before I ever bought my first individual stock shares. Even now, with all that I’ve learned, mutual funds remain a crucial part of my investment strategy.
Here’s a simple introduction to mutual funds.
Instead of the boring textbook definition, let me explain how mutual funds work using an example. Imagine you decide to buy some stocks and want to assess the risk.
If you buy one stock, it might go up, or it could go all the way down to $0. Ouch! That’s too risky for your entire retirement fund. So, let’s diversify by buying five stocks. This is slightly better. One or two might perform well, while one or two might not. The gains and losses could balance out, but there’s still a chance all five could tank. Not exactly secure yet.
Now, what if we buy 500 different stocks? Our chances of going broke are much lower because we’re spreading the risk. But who has the money for 500 stocks at $7.95 a share? That adds up quickly!
Here’s where mutual funds come in. Imagine gathering money from you, me, and a few thousand other people to create a large pool of funds. This way, the commission costs become insignificant. Essentially, mutual funds are a pooled investment fund that spreads money across various investments.
Mutual funds don’t just have to be stocks. They can include a variety of investments such as:
– Stocks (value, growth, large cap, small cap, domestic, foreign)
– Bonds (government, corporate, junk, municipal)
– Cash (CDs, money market)
– Real estate
– Even other mutual funds
The specific contents of a mutual fund can change over time, and most investors focus more on the fund’s goals than its exact composition.
Why are there so many kinds of mutual funds? Each one targets a specific goal for a specific type of investor:
– To make a lot of money (with higher risk). For example, funds that invest heavily in foreign stocks or real estate.
– To be ultra-safe (with lower returns). For example, funds that focus on government bonds.
– And many options in between.
A common criticism of mutual funds is that they move too slowly compared to the thrill of individual stocks. However, you rarely hear about people losing 90% of their investment in a mutual fund, which can happen with poorly chosen stocks. Mutual funds, while more stable, still require careful selection.
Critical factors when choosing mutual funds include:
1. Performance: We invest to make more money. So, look for funds with a strong track record (they haven’t lost a lot over the years). Always remember, past results don’t guarantee future returns, but they can help you avoid bad picks.
2. Expenses: Mutual funds have costs associated with acquiring and selling their investments. Some funds pay managers to choose investments (active funds), while others follow known benchmarks like the S&P 500 (passive funds). Aim for funds with the lowest fees, which include:
– Taxes: Normally, you pay taxes on mutual funds unless you’re using a retirement account, like a 401(k) or an IRA. For long-term benefits, consider purchasing through a Roth IRA.
– Loads: These are fees, and if you hear “front load” or “back load,” steer clear. Go for no-load funds, which don’t have these extra charges.
– Expense ratio: This is an unavoidable annual fee for managing the fund, expressed as a percentage. Look for great performing funds with the lowest possible expense ratios.
I hope this guide helps clarify what mutual funds are and how they can fit into your investment strategy. If you have more questions, feel free to ask in the comments.
