What Is a Mutual Fund?
A mutual fund provides an opportunity for a group of investors to work toward a common investment objective more effectively by combining their monies to leverage better results. Mutual funds are managed by financial professionals responsible for investing the money pooled by the fund's investors into specific securities, usually stocks or bonds. By investing in a mutual fund, you become a shareholder in the fund.
Mutual funds can provide a steady flow of income or can be engineered for growth in the short or long term. The success of the fund depends on the sum of its parts, which are the individual stocks or bonds within the fund's portfolio.
Just as carpooling saves money for each member of the pool by decreasing travel costs for everyone, mutual funds decrease transaction costs for individual investors. As part of a group of investors, individuals are able to make investment purchases with much lower trading costs than if they did it on their own. The biggest single advantage to mutual funds, however, is diversification. Diversification, the easy accessibility of funds, and having a skilled professional money manager working to make your investment grow are the three most prominent reasons that funds have become so popular.
The History of Mutual Funds
Currently, the number of mutual funds exceeds 10,000, but as recently as 1991 the number was just over 3,000, and at the end of 1996 it was listed at 6,000. Stock funds are growing as a way to play the market because they don't require the investor to make purchasing and timing decisions.
Bond funds are also growing, partly because of the complexities associated with understanding individual bonds. Bond funds are also a way to hold more bonds than the average investor could afford by buying them on an individual basis. Money market funds offer a safe alternative to bank accounts (though they are not FDIC-insured), and provide higher interest rates.
As late as the early 1950s, fewer than 1 percent of Americans owned mutual funds. The popularity of funds grew marginally in the 1960s, but possibly the largest factor in the growth of the mutual fund was the individual retirement account (IRA). Legal changes made in 1981 let individuals, including people who already participated in corporate pension plans, contribute up to $2,000 a year into a tax-advantaged retirement account, which could be invested in (among other things) mutual funds. Mutual funds are now mainstays in retirement accounts like 401(k)s, IRAs, and Roth IRAs (which you can read more about in Chapter 20).
The first index funds were offered by Vanguard. And the first one they offered, created by Vanguard founder John Bogle in 1976 and originally called the First Index Investment Trust, is today's Vanguard 500 Index fund. In November 2000, it became the largest mutual fund, holding approximately $100 billion in assets.
By the end of the 1980s, money market mutual funds had become a bit of a cult. They offered decent returns, liquidity, and check-writing privileges. But would-be investors wanted more. Then, with computers and technology making information more readily available, the 1990s ushered in the age of the mutual fund. The Internet allowed financial institutions to provide a great deal more information than they could on television commercials or in print ads. They reached out to everyone, not simply those Wall Streeters who read the financial papers. People saw how easily they could play the market and have their money spread out in various stocks as well as bonds.
Mutual Funds Today
Every financial institution worth its weight in earnings has a wide variety of funds to choose from. In fact, in 2007, 48 percent of U.S. households owned at least one mutual fund. That makes for about 88 million mutual fund shareholders in this country. Among these 51 million households, the median fund investment is $100,000. And worldwide, there's over $26 trillion invested in mutual funds.
Purchasing funds today is as easy as making a phone call or sitting down at your computer. Fund families (large investment firms or brokerage houses with many funds) noted the surge in popularity of electronic trading. To make funds easily accessible to all investors, they created toll-free numbers and websites that make it easy for you to buy and sell mutual funds. Transactions can also be made by the old-fashioned method of snail mail.
Another benefit of mutual funds is their liquidity, allowing you to convert shares to cash. A phone call allows you to sell your shares in the fund at its current net asset value (NAV, or posted rate per share). You should have your money in three or four business days.
Electronic trading has allowed investors to trade at all hours from the comfort of their own homes. It's not hard to find the top ten, twenty, or fifty funds, as rated by some leading financial source, and then buy them online. It is also not hard to get addicted to trading and find yourself overdoing a good thing. The accessibility and ease of trading online and through toll-free numbers has landed many overzealous investors in deep trouble. Many new investors, eager to see quick profits, need to develop the patience and research skills necessary for successful long-term investing.
Investing in a mutual fund is less risky than owning a single stock. That's because the fund is managed professionally and is diversified. Mutual funds offer you diversification without making you do all the work. Funds can hold anywhere from a few select stocks to more than 100 stocks, bonds, and money market instruments. While some funds own as few as twenty or twenty-five stocks, others (like the aptly named Schwab 1000) own 1,000 stocks.
This diversity minimizes much of your risk. If you invest everything in a single stock, your investment is at the total mercy of that stock price. If you buy six stocks, you assume less risk, as it is less likely that all six will go down at once. If three go down and three go up, you would be even.
Mutual funds work on the same principle of safety in numbers. Although there are funds with various levels of risk, many mutual funds offer the investor limited risk by balancing higher-risk investments with lower-risk and thus safer investments. Diversity acts to your advantage as it protects you against greater swings in the market, be it the stock or bond market.
Further diversification can also come from buying more than one fund. You can allocate your assets into different types of funds. If you buy into a few funds in different categories, you'll have that much more diversification and that much less technical risk. For example, your portfolio might include the following:
A more conservative bond fund
A tech fund to cash in on a hot industry
A higher-risk international fund
A low-risk blue-chip fund
A growth fund
However, keep in mind that it's usually not advisable to have more than six or seven mutual funds at a given time, or you can start to counterbalance your efforts to construct a strong portfolio.
The idea is to balance your portfolio between more and less conservative, or higher- and lower-risk investments. Your needs will guide how you diversify. One investor might have 10 percent in bond funds, 20 percent in growth, 30 percent in tech, and so on, while another has 5 percent in tech and 40 percent in blue-chip. That's why there is no one stock investment strategy that's suitable for all.
It seems odd to need to diversify your mutual funds since the job of the fund is to diversify the stocks, but it's all part of building a solid investment portfolio. Your mutual fund is the sum of many parts. Therefore, you may want another fund in your portfolio. Another significant reason for diversifying your mutual fund investments is to spread your assets out across sectors, industries, and asset classes. A fund manager, no matter how skilled, is limited by the goals and the direction set forth by the fund.