There are a lot of terms thrown around in the financial industry – a lot.  If you haven’t spent much time studying or are just trying to get into handling your personal finances well, you’re likely running into a few terms that you’ve heard of before but don’t understand completely.

One of those terms for many people is “Mutual Funds.”

Mutual Funds?

Everyone has probably heard of mutual funds, and if you’ve got a retirement plan, you’ve likely invested in a few.  They’re important to understand if you’re going to do any investing – because you NEVER invest in something you don’t understand.

I hope to simplify this down so you can share this with a friend who doesn’t know a single thing about investing.  It’s important for you to check with a financial adviser who can help you understand if mutual funds (and what type) are the right investment for you, because there are over 8000 different funds to choose from!

The Concept of a Mutual Fund
A mutual fund is a pool of money generated by investors (people that are looking to make money).  That money is then invested into specific businesses (stocks), bonds (other people’s debt), or other types of investments.  This is done by a “fund manager.”  The fund will likely invest in hundreds of different stocks or bonds.  The type of investments the fund makes depends on its founding document, called a “charter.”

How You Make Money in a Mutual Fund
You make money over time in a mutual fund as the value of the fund increases.  The value of the fund increases when the stocks or bonds within the fund increase in value over time.  Just like if I owned a rare baseball card, and the value went up over time, I didn’t “earn interest” like in a bank account, but the value of what I owned increased over time.

Let’s look at an example of this:
Apple stock (makers of iPhone, iPad – that Apple) has been really hot over the last few years.  In May of 2007, Apple stock hit $100.  Because of great sales and company growth over the last few years, it is currently worth over $450.  To keep it clean, we’ll say that was a gain of $350, over 6 years.  Not bad.

AAPL

If the fund had invested $10,000 and purchased 100 shares of Apple stock in May of 2006, that Apple stock would now be worth $45,000.  That increased the value of the mutual fund by over $35,000!  And this is only one of dozens of different investments that the fund makes.

Why People use Mutual Funds
Mutual funds are a great investment vehicle for many people.  Theoretically, they allow you to mitigate your risk, while enhancing your gain.  

This is done through diversification, which is a $10 word that means “spreading it around.”  A mutual fund has hundreds of different investments (called “holdings”) in different companies, so if one goes poorly, it’s not as bad as if you personally picked a bad stock and put a bunch of money in it. 

Also, if a certain sector of the market is doing well – technology, pharmaceuticals, energy, consumer goods, etc. – you likely have some investment in that sector, so you get to be a part of that gain.

When to use Mutual Funds
Over the long-haul (10-30 years) mutual funds are a great investment for most people, as a good fund will likely give you an average annual return of anywhere from 8-12 percent.  You don’t use mutual funds for your emergency savings, or summer vacation, or furniture.  Mutual funds are for retirement, college planning, and long-term investing.  

The important thing is to have a long-term perspective when using mutual funds.  You should plan to leave your money in a fund at least five years if you are going to put your money in one.

There’s a lot more you could learn about mutual funds, but this should give you enough knowledge to understand what people are talking about when they mention them.  

I’ll get into some other discussions about when and how to use mutual funds – and how to find a good one – in a future post.  In the meantime, if you’re looking to invest in mutual funds, sit down with a good Certified Financial Planner to help you get started.  I know a couple of excellent ones if you need suggestions.

Question: Do you use mutual funds in your financial plan? What’s confusing to you about mutual funds still?