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What Is A Mutual Fund?

mutual-fundsWhat is a Mutual Fund?

NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. Please consult with your financial advisor before taking any action. For planning advice contact Polaris Financial Planning.

When I was a kid I loved looking at numbers, charts and graphs. I'm sure it was not the norm for my age but I remember looking at stocks in the news paper. Nothing like the smell of a newspaper and its ink on your fingers.

When you buy a stock, you buy a small piece of a company. If you put all of your money in one company you can make a lot if the company does well but you can also lose all of your money if the company goes broke. Remember Enron?

For more on the value of diversification read this....

According to Investopedia the modern mutual fund began in 1924.

The creation of the Massachusetts Investors' Trust in Boston, Massachusetts, heralded the arrival of the modern mutual fund in 1924.

NOTE: I will be talking about Open-end mutual funds. Closed-end funds are different and I don't recommend them.

A mutual fund allows people with small amount of money (<$10,000) the ability to invest in the stock market and reduce their risk (vs. one stock). Studies have shown that owning just 10 stock can limit your volatility (risk) by half and 30 stocks reduce your stock risk to almost the same level as owning 500 stocks (Standard deviation of 20.87 vs. 19.27). If you had to buy the stocks and invest just $3,000 in each one, you would need $90,000 to have a diversified stock portfolio. Each time you want to add money you would have to buy more shares in one of the stocks and, of course, pay a commission on the trade.

The modern mutual fund solves many of these problems. You can usually start with a few thousand dollars and can add money at any time. This type on investing can help keep your costs down.

Sadly 53% of Americans don't own any stocks.

Wikipedia lists these advantages for mutual funds....

  • Increased diversification: A fund must hold many securities. Diversifying reduces risks compared to holding a single stock, bond, other available instruments.
  • Daily liquidity: Shareholders may trade their holdings with the fund manager at the close of a trading day based on the closing net asset value of the fund's holdings.
  • Professional investment management: A highly variable aspect of a fund discussed in the prospectus. Actively managed funds funds may have large staffs of analysts who actively trade the fund holdings.
  • Ability to participate in investments that may be available only to larger investors: Foreign markets, in particular, are rarely open and affordable for individual investors.

I agree with all of the above points.

  • Ease of comparison: Picking a mutual fund is a lot like judging a dog show. You select the best of the breed which has the qualities you seek.

I disagree. It is very hard to pick a good mutual fund. Ironically, picking funds that have recently done very well can actually increase your risk. This is why I recommend and put my money in Index Funds.