NOTE: The inclusion of a company logo in the header image above does not constitute investment advice.  Seek professional investment advice before dumping money into a fund managed by one of the companies above, duh.

When we get into talk of investing, it can get confusing pretty quickly.  I like to break things down and try to keep them simple.  When I recommend that people start investing, I encourage the use of mutual funds.  Mutual funds represent a great investment opportunity for the average investor.

1) Mutual funds are pools of money that invest in stuff.

The total amount of money in a mutual fund could be billions of dollars.  That comes from individual investors like you and I, as well as large companies that may have 401(k) plans accessible to those funds.  One fund I’m invested in currently has $141 billion in assets.  That money is invested to provide a return for the investors.

2) They mainly invest in stocks and bonds.

You can tell what a fund invests in by how it’s labeled.  A “bond fund” invests in bonds, a “growth stock mutual fund” invests in stocks of growing companies, and and “international fund” invests in companies whose headquarters are overseas.  When you’re invested in stock mutual funds, you “own” a very teeny part of those companies that are in the fund.

3) You get a return when the fund’s value grows.

When you invest in a mutual fund, they don’t just pay you for having money in the fund.  You get a return on your investment as the companies in the fund do well, and their value increases.  Let’s look at a simplified example of how this works:

William Ray mutual fund

Let’s say you bought into William Ray’s Mutual Fund (LOL) for $500, and we invested $100 in each of those five companies listed above.  Let’s just say over a year the value of the Apple stock went up $20, the Home Depot stock up $10, the Intel stock $12, the Coca-Cola stock $5, and McDonalds up $8.

This would be a good year, and the value of your investment would have gone from $500 to $555, an increase of 11%.  While actual mutual funds are more complex than this, this helps illustrate how you earn money from one.

4) Mutual funds are actively managed.

Mutual funds have people that manage them, which can be an asset or a liability.  Each one has a “fund manager” (read: financial nerd) who has lots of experience in the investment world.  Each manager has a team of financial nerds that do analysis to help make decisions about how to invest the funds assets.  Funds generally charge a fee of 1-2% for this.

This  stands in contrast to Electronically-Traded Funds, or ETFs, which are managed by a computer algorithm.  They generally have lower costs associated with owning them.  Traditional mutual funds and ETFs have been in a bit of a rivalry the last few years as the debate has raged about if an actively-managed fund can outpace the returns generated by an ETF when considering fees.  ETFs can often beat the average mutual fund, which is why I recommend having someone help you find the funds that are better than average (see #7, below).

5) Mutual funds are naturally diversified.

“Diversified” simply means spread around, not having all your eggs in one basket.  If you invested all your money in one company, and that company went under, you’d be sunk.  Diversification, spreading around your money, is a vital part of being a successful investor.  That’s the beauty of mutual funds – when you invest in one, you’re automatically spreading your money around to dozens of different companies.

6) Mutual funds can be held within a retirement account.

Mutual funds are an investment that can be held with or without a retirement account like an IRA or 401(k).  Owning them within tax-favored retirement plans bestows great advantages.  With a traditional IRA or 401(k), you can invest tax-free dollars into the fund, then pay taxes when you take the money out at retirement.  With a Roth IRA, you can invest already-taxed dollars so that all the money and growth inside that IRA is tax-freeIt’s a beautiful thing.

If you don’t hold the funds inside a retirement fund, it’s not a bad thing, it just means that when you sell, you’ll have to pay capital gains taxes.  You pay taxes on the amount of money you’ve earned from the investment, not the entire amount invested.  In our example above from William Ray’s mutual fund, I would have paid taxes on my gain of $55, not the total $555.

7) Not all mutual funds are created equal.

In a universe of over 7700 mutual funds, there are going to be winners and losers.  How do you wade through all of those and pick the ones that are winners?  Picking the right funds isn’t necessarily the key, but you want to make sure that you’re in good, solid funds, with long track records and great average annual returns of over 10%.

They’re out there, but it’s best to have someone in your corner helping you figure that out, so I recommend having a registered investment advisor with the heart of a teacher to help you navigate the process.

Once you understand them, mutual funds can be a great investment tool for individuals.  Hopefully this helped you understand them on a new level!

Question: Do you use mutual funds for investing?  What are some of the disadvantages of mutual funds?