How Mutual Funds Work: A Quick Overview for Dummies

You might have heard that the 1929 stock market crash drove executives to jump out the windows of skyscrapers. More recently, the swift collapse of Enron stock in late 2001 shocked investors worldwide. These horrific stories paint a picture of stock investing as a risky art, where even seasoned day traders are prone to blowing fortunes. There is however an option that offers many of the opportunities of stock investing without the risk. This is of course mutual funds (especially the equity variety).

Investing Without all the Stress

Mutual funds make investing safer and far less demanding for the average person. Think of a mutual fund as a cornucopia of investments such as stocks, bonds and securities all selected in the perfect proportion by a skilled fund manager. As the market changes, it is the job of the manager to re-adjust the individual investments contained in the fund. This makes it a hands-off solution where you can buy into the financial skills of an expert along with other private investors.

Easiest Way to Diversify

Besides built-in management services and greatly reduced risk, mutual funds allow people with a modest amount to contribute instant diversification. As the old saying goes, it is never wise to keep all your eggs in one basket. Each mutual fund is like a miniature diversified portfolio ready-made for a specific investing purpose. This brings us the next point: why so many different types of mutual funds exist.

Low-Risk and High-Risk Funds

Any worthwhile investment carries risks with it. Risk refers to the possibility that your investment will fail to make a return that keeps up with inflation or worse, ends up costing you money.

Even low-risk mutual funds show trends that spike up and down to some degree, however it is easy to see the upward, steadily climbing pattern. The downside to going for stability is that in the long-term potential for growth isn’t as high as more risky investments. For short-term investing or people nearing retirement age, low-risk mutual funds based in fixed investments such as bonds and money market funds are a good choice.

High –risk mutual funds are far more volatile than low-risk, meaning that the value of the fund will spike and dip sporadically from month to month and year to year. In the long-term these ups and downs are meaningless if the fund is well-managed. Along with higher risk comes far greater potential for these funds.

Types of Mutual Funds

Every fund has a prime investment objective. When choosing a mutual fund, the key is to select a fund that has an objective that lines up with your investing goals. At the most basic level, there are three main varieties. Each is listed here from highest risk to lowest.

1. Equity: Investors looking for aggressive growth and long-term gains like this higher-risk approach. Equity funds focus on stock market investing.
2. Fixed-Income: This is a low-risk approach designed to preserve capital by investing in fixed-income securities such as mortgages, bonds and preferred shares.
3. Money Market: This approach favours fast gains and rock-solid stability. The money market is made up of debt instruments such as T-bills.

Performance

The performance of a mutual fund depends on how well each of the individual securities does.

Most importantly, the choices of the manager can either make the fund a star player or dud. You can check into a fund’s track record before you commit.

Sites such as MorningStar, allow investors to track how well each mutual fund in their portfolio is doing. Also, there may be expert advice about the particular mutual fund, a stewardship grade assessing the quality of the management and a rating, generally giving you an idea of how well the fund is regarded among experts.

Management Fees

Some see management fees as the biggest drawback to mutual fund investing. Competent fund management doesn’t come cheap as it requires full-time activity from the stars of the financial world.

A salary is paid to managers for keeping the fund afloat through thick and thin. The amount is based upon the assets: anywhere from 0.5% to 1%. Although it doesn’t seem like a lot, these charges eat into returns fast enough to make mutual fund managers among the richest people in the country.

Look at the MER (management expense ratio) when considering a fund. Keep in mind that a lower MER doesn’t necessarily mean better because the best-performing managers require higher fees.

Conclusion

If you like carefully choosing investments without the biased advice of bank employees, learning about self-directed mutual funds is a great way to get your feet wet in investing. You don’t need a large sum to start, options are practically unlimited and buying and selling regularly is unnecessarily.