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The Beauty of Mutual Funds

The two tenets of investing in the stock market are: “Diversification” and “Buy Low, Sell High.” Simple in spirit, difficult in execution. Mutual funds help you with the first rule of “diversification”, but you’re on your own with “buy low, sell high.” You’ve probably heard of mutual funds before and chances you may even own shares in a mutual fund, but do you really understand how they operate? What’s the load on your fund? Who is the investment manager and what is his or her track record?

A mutual fund is technically a company that holds a portfolio of investments; sometimes people refer to the mutual fund as the portfolio itself. The distinction is minor and not terribly important, but for clarity’s sake the fund actually refers to the “company.” A professional investment manager who manages the various securities held by the fund in its portfolio, that’s how a fund brings “automatic” diversification, runs the fund itself. When you invest in a fund, you’re purchasing shares of the company just as you would with the shares of any other public company.

What is a fund’s load? It’s how much it costs for you to buy shares of the fund. The load goes to the salesperson as commission for their hard work (read this article [3] for great questions to ask that broker). A fund with a load can be front or back loaded, referring to when the charge is actually incurred. Front-loaded funds charge when the shares are purchased and back-loaded funds are charged when the shares are sold. There are a lot of no-load mutual funds out there where the fund charges 0% as a sales fee. A load charge of around 3.5% is considered low-load and they can get as high as 8.5%.

You decide to go with a mutual fund because you want diversification and each fund publishes a prospectus where they explain the goal of the fund and how they intend to meet that goal. For example, the Vanguard Target Retirement 2045 [4] invests in other Vanguard funds with a strategy “designed for investors planning to retire in or within a few years of 2045.” The idea is to be riskier now and more conservative as 2045 rolls around. So, if you’re planning on retiring in 2045 and want someone to manage your portfolio so it’s risky now and conservative later, then go with 2045. A popular choice for many is to simply find an index fund that matches something like the S&P 500 so they’re guaranteed to match the market. Vanguard has been known to be very good with these index funds since their fees are much lower.

In addition to the direction of the fund, the prospectus will tell you what the fund’s benchmark is. A lot of them pick the S&P 500, sometimes the NASDAQ or even the Dow, but I’ve never really felt that this piece of information was terribly important. I mean if the market is down and the fund is down less, that’s good and the benchmark will tell you that. Also, when you make those sort of comparisons you’re looking at snapshots in time and not the overall trend. So benchmarking can be deceptive and I always look at them with a grain of salt.

I hope this served as a good, albeit brief, introduction to mutual funds. It’s a nice way to get involved in the stock market if you’re not already or it’s just some good information about what your 401k is doing (since you’re probably investing in funds in your 401k).