What Are Mutual Funds and How Do They Work for the Average Person?

What Are Mutual Funds and How Do They Work for the Average Person?
  • Opening Intro -

    Mutual funds have become very popular in the last 20 years. But why have they become so popular?

    Simply put, they are a way for the average investor (read : us) to get a chunk of the market, without reading 10 finance books, getting a PhD in Economics or sitting all day reading news from Wall Street.

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80 million people invest in mutual funds each year. If you are one of them, keep reading. If you are not one of them, keep reading.

80 million people are around one in every household in America. This means that the market for mutual funds has trillions of dollars.

Mutual funds have become very popular in the last 20 years. But why have they become so popular? Are they better or worse than other investment ideas? And finally, how do people invest in mutual funds?

Mutual funds have many types, which we won’t get into here. Simply put, they are a way for the average investor (read : us) to get a chunk of the market, without reading 10 finance books, getting a PhD in Economics or sitting all day reading news from Wall Street. They are a way of buying in a certain part of the market; let’s say renewable energy, technology, or cleaning products, which you couldn’t do without the help of such a fund, only if you had considerable knowledge (and capital).

The idea of the mutual funds is very smart, but they haven’t always lived up to the initial hype. Mutual funds are nothing but a collection of stocks and bonds. You gain money from dividends (on stocks) and interest (on bonds). They are managed by a team of professional investors, which gather a lot of money from the market, so that your risk as a small retail investor is minimized.

The main advantages of mutual funds are professional management, simplicity and diversification. Let’s put it this way: Through diversification, your risk is almost completely mitigated. Even if one stock fails, you have hundreds of other stock you have invested in using the fund. You cannot achieve this on your own, due to lack of capital. Furthermore, it’s very easy to buy a share of this fund.

Sounds perfect, doesn’t it? Well, here are the things to watch out for:

Professional management

Yes, you read correctly. Management is by no means perfect, and professionals can often even UNDERperform the S&P 500, for example.

Costs

Running a mutual fund is no easy business, and the costs of investing in one can be significant.

Dilution

Small risks and high diversification also ensures that your potential income is often capped. You cannot become rich quickly with a mutual fund or even do much better than the standard indexes. They are better than a savings account, for sure, but don’t think you will be looking at 15% / year returns.

There are, of course, different types of funds. At fundamental level, there are 3 types of funds:

  1. Equity funds (stocks)
  2. Fixed-income funds (bonds)
  3. Money market funds

All mutual funds are a variation between these classes. Depending on the majority of financial assets which are contained in every fund, the degree of risk and potential returns may vary. There are funds that are called sector funds of environmentally friendly funds, which contain different criteria for investing.

Another investment strategy you should consider is paying off your mortgage. The savings from a mortgage payment can be made into a mutual fund for future retirement planning:

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The most important issue, however, is picking a mutual fund and learning to read their performances. Firstly, one must identify the reasons for which he wants to invest in a mutual fund. Are you following big gains, or are looking for 30 years of stability? Do you want low cost, very simple funds or funds which allow you a high degree of freedom, where you feel like a partner of those working at the fund? How much money do you have to invest?

Regarding the evaluation of a fund’s performance, everyone knows they are expressed in percentages. A lot of funds will astound people with their one year performances – don’t fall for that. It’s easy to catch a good market flow and score big points on one day, but remember you might be investing for 30 years. If so, you should be looking at a fund that has a good year over year ratio for the past 20 years. Make sure they haven’t lost money between years, or if they have, the percentage was either small or meaningless.

Finally, always remember to subtract their operating costs from the percentage of their gains. Remember that access to these funds is not free.

This article was meant to provide some light regarding mutual funds. It is only meant to build appetite, and not as a main course. Share it with your friends so that you can each research which fund would be best for you and compare results! Anything is more fun when done in a team, so don’t hesitate to involve as many people as possible in your future investing activities.

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