Understanding Mutual Funds

How They Work and How They Help

Mutual funds are an understood staple of the financial industry. Most people have heard of a mutual fund, but some still don’t understand what they are, how they work, and why someone would or would not want them in their portfolio.

What is a Mutual Fund?

A mutual fund is an investment vehicle in which investors can pool their money to own pieces of stock in a group of companies. Mutual funds are professionally managed, giving investors an opportunity to diversify their investment without using their own time to actively manage it. This professional management comes at a cost where fees will be taken from the investment over time.

Most mutual funds are directed towards achieving a specific investment goal. Some of those investment categories include aggressive growth, growth, value, balanced, and asset preservation. They can be further broken down between the different kinds of investments being held in the fund.

Kinds of Mutual Funds

Funds do not fall into neat little packages. Different funds are looking to achieve different results in different ways. Generally speaking, we can separate funds into a few categories.

Money Market Funds

These funds are primarily interested in maintaining your assets. They invest in safe financial instruments like certificates of deposit, commercial paper, and U.S. Treasuries. The funds create returns that are only slightly above the rate of inflation and are therefore not a vehicle that should be considered for retirement savings. Money market funds should only be used as a place to park money for a period of time. They are safer and more liquid than other funds.

Bond Funds

While many different kinds of bond funds exist, they all operate with a goal of maintaining some kind of fixed income. They do this by investing in debts such as debentures, mortgages, and treasury bills. Depending on the types of debts the fund is investing in, they could be providing taxable or non-taxable income. Once a bond reaches maturity, that debt is paid off and you will no longer receive interest from that bond.

Equity Funds

If you own an equity fund, your investment owns a portion of the companies held within the fund. Equity funds have a goal of growth, but how each fund aims to achieve that growth could be dramatically different. Funds will invest in a mixture of small, mid, and large-cap equities as they see fit in order to reach their own stated objectives.

Balanced Funds

Balanced funds use a mixture of equity and bonds. They use the more conservative debt securities to off-set some of the risk that comes with owning higher-return equity. These funds will come in many varieties as each seeks to grow more aggressively or conservatively.

Specialty Funds

Just like many other funds, specialty funds come in many shapes. They are usually focused primarily towards getting involved with a particular kind of investment such as technology, retail, real estate, or currencies. This is also where you would find socially-conscious investing. Overall, specialty funds are for the people more interested in where their money is working.

Comparing Fees and Making a Decision

While returns are important, they cannot always be guaranteed. We don’t have control over what happens in the market. We can control the amount of research we do to find the fees associated with each fund.

Usually, the difference between fees in a mutual fund will be less than one percent, but this can make a dramatic and painful difference in your final account value. No amount of fees should be ignored.

Your primary objectives in selecting a fund should be as follows. First, find funds that are suited to your needs. If you are younger and have a long time to invest, you can take on more risk and volatility, but you shouldn’t take that as a reason to dump all your money into one aggressive fund. Invest at the level you are comfortable with. If that is more conservative, be more conservative.

Next, compare the funds that match the investment strategy you are looking for. Compare the assets the funds hold and their history of returns. Above all else, compare their fees to see which is lowest. The fund with the lowest fees may not be the best for you, but it is certainly an advantage to consider.

Overall, understand what mutual funds provide. They are an effective way for you to diversify your investment in an account that you don’t need to actively manage. If you don’t want to get involved in the minutiae of investing, mutual funds are a good way to get your money in the right places. With that said, even as a passive investor, you should know what is going on with their money.

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