Mutual Funds Explained Pretty Clearly

Jan 02, 2003 |Todd Temple

For the small-time investor, mutual funds may be just the thing.

Many types of investments are priced for people who have several thousand dollars to work with. Mutual funds are among the exceptions. Though they’re popular with big-money people, they work for the small investor too. This month we’ll discuss why a mutual fund can be good deal even when you don’t have a lot of cash to invest.

Let's say you have just $500 for investing. You could buy 100 shares of a stock trading at $5 per share, but that’s not smart: If the stock tanks (and at $5 a share, it hasn’t far to fall), you lose it all. Better to spread your money around.

One way to spread your investment is to buy shares of stock in several companies. But in the stock world, $500 doesn’t go very far. If you spend it buying $100 worth of stock in five companies, you’ll pay five transaction fees. What’s more, you’ll probably be buying less than 100 shares of each stock. Since shares are typically traded in batches of 100, you’ll be charged an extra fee for dealing in these troublesome "odd lots." All these pesky fees quickly eat up your meager investment capital, making it that much more difficult to achieve any gains.

Here’s another way: Find nine friends who each have $500 to invest. Put all your money together to create a $5,000 fund. Now you can buy several stocks with this fund and spread the risks and costs between you. Your share in this fund is 10 percent of every stock owned by the group. If one company doesn't do well, the performance of the others can offset the loss.

The problem with this plan is that it’s hard to find nine friends with that much money to invest. And even if you find them, trying to agree on which investments to make can wipe out a bunch of friendships in a hurry. Which leads us to mutual funds.

A Big Club for Money

With a mutual fund, thousands of people invest varying amounts, and professional managers choose which investments will be best for everyone in the group. Since the fund manager often has millions or billions of dollars to work with, he or she can spread the money around, investing in 50 to 100 different securities (stocks, bonds, etc.). The result: Your small investment is treated with the care and expertise of a big one.

There are hundreds of funds to choose from, each with specific investment goals to appeal to certain kinds of investors. Here are the most popular types of mutual funds:

Growth Funds invest your money in securities (stocks, bonds, etc.) that will (hopefully) increase in value. Aggressive growth funds invest in new and growing industries and companies with risky but potentially big-time futures. Moderate growth funds take their chances with more established, growing companies. If these companies do well, the value of their stocks rise and so does the value of your mutual fund shares. If they do poorly the value goes down.

Equity Income Funds invest in stocks that pay regular dividends. You receive a quarterly check of your share of all the dividends paid to the fund. In some cases, you can arrange to have your dividends reinvested (i.e., used to buy more shares in the fund).

Growth & Income Funds invest in both kinds of securities: If the fund manager is successful, the value of your shares goes up and you get some dividend money each quarter.

Money Market Funds invest in bank CDs (certificates of deposit), Treasury bills (short-term loans to the government) and other short-term loans to corporations and government agencies.

Bond Funds invest in bonds, which pay steady interest.

Some mutual funds focus on a specific portion of the economy as a way to achieve their goals. Tax-Free Funds invest in government bonds: The government makes investing in these lower-yield bonds enticing by allowing you to exclude the dividends from your taxable income. Most college students don’t have tax bills large enough to justify this type of investment.

Other funds invest in a particular industry, region or country: a Sector Fund may invest only in technology companies, or agricultural firms, or those in the aerospace business. International Funds invest in specific foreign regions or countries, such as companies based in Asia, or those doing business in Mexico. Precious Metal Funds invest in companies that mine and sell gold, silver or platinum.

As a general rule, growth funds seem best-suited for college students. They're riskier than most of the others, but they have the potential to make you more money: an aggressive growth fund could yield 30-40 percent in one year — or lose that much or more. And if that’s too scary, there are plenty of less-radical mutual funds that still tend to do much better than your bank account.

Unless you need every dime of your money to spend for college next year, you can probably afford to take moderate risks with your money. Invest no more than half of your savings in a solid mutual fund. If the fund is risky (potential for big losses), don't put in more than a fourth of your savings.

How to Invest

Most mutual funds are sold directly by the investment companies and financial institutions that manage them. But before accepting your money, a fund is required to send you a prospectus — a report describing the fund’s investment goals, risks, trading procedures and past performance. After doing your research and reading the prospectus, if you do decide to buy shares in a fund, you’ll have to send a check for at least the minimum amount, typically $500 to $1,000. After that, you can usually make additional investments of $250 or more, as often as you like.

If you're buying a load fund, you'll also have to pay a commission to the fund manager — from 3 to 8.5 percent of your investment, depending on the fund. There's generally no charge when you sell. (Just to be different, some load funds charge an "exit fee" when you sell, but nothing when you buy. A few get you at both ends.) A no-load fund won’t charge you a sales fee. Some funds have limits or penalties if you sell your shares back to them too quickly; the prospectus describes these and other fees.

Many funds perform well only during certain stages of an economic cycle: A fund that’s hot at the beginning of a period of economic good times may lose all its sizzle — and some of your money — in the middle of the cycle. Some funds are so temperamental that you’ll see them at the top of the performance list one month, and at the bottom the next. It’s important to consider a fund’s one and five-year track record. All-weather funds tend to survive the ups and downs better. They may not have killer performance records each month, or even for the past year, but their five-year record is impressive.

Before You Buy

As with any investment, it pays to do your homework before you buy into a mutual fund. Many news and business magazines print regular reports on mutual funds, allowing you to compare their track records. And of course you can find plenty of information of the Web. Beware of funds that show recent, colossal gains: As the prospectus themselves claim, past performance is no guarantee of the future. Pick the right fund and you’ll see your investment grow much faster than your savings account. At least that’s what it should do. Remember, with a mutual fund there’s no money-back guarantee.

Copyright 2003 Todd Temple. All rights reserved.  

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