Who’s ready to get back into the BB Investing Project?? I know it’s been a few weeks since we last delved into your investment education, but never fear, ladies (and gents) – we are back on track and ready to continue on our journey to the land of the well-funded retirement (ugh, I can’t wait to spend winters where there is no snow!). The topic this week? Mutual funds. It’s a boring name, but they can have an extremely great pay-out. And most importantly, it’s where I keep most of my retirement moo-lah! Intrigued? Ready to be on the same path as I am? Read on.
WHAT IS A MUTUAL FUND?
In financial terms, it is a collection of investments. In non-financial terms, think of it as a one of those old Lisa Frank folders that looked like a My Little Pony vomited all over it, housing your stocks or bonds inside. Here’s how it works: the big guy (or gal) in charge of the mutual fund will choose a selection of stocks or bonds to invest in based on the goals or direction of the fund (i.e. long-term growth, income-based, etc.). They will then divide this package of stocks and bonds into smaller portions (called shares), and sell those shares to you, as an investor, thus allowing you to have your hand in the pot. For you visual learners out there, here’s an illustration.
Now how do you make money? Well, let’s say that you bought 1 share of a mutual fund that had, in total, $100 worth of investments. Your share would have cost $1. A month later you come back to look at how you’ve done and realize the total investment has gone up to $105. Your share now is worth $1.05, meaning you earned 5 cents (or 5%) in one month. Comprende, amiga?
TYPES OF MUTUAL FUNDS
A mutual fund can be made up of either stocks or bonds, but they basically follow the same format in how they work; thus, I’ve made the executive decision to just focus on stock-side of mutual funds in this post, so we’re saying adios to bonds for now.
Now, most mutual funds fit into one of the boxes below. The value style represents high-quality companies who still have strong financials but whose stock price has dipped for one reason or another (i.e. Procter & Gamble). The growth style, on the other hand, usually represents those companies who aren’t well established but have the potential to become extremely successful companies (i.e. Tesla).
Want to try to guess where these companies fall within this grid? Try it out – answers are at the bottom of the post!
Ok, now that that’s over, let’s get back to it. You can further categorize these funds based on geography (i.e. international), sector (i.e. technology or health), or socially-responsible (sorry, Marlboro, you won’t get our money), so you can find something that fits what you are really looking for. Don’t get overwhelmed by all of your choices, though – we’ll walk through the main fund types you should focus on in a later post. Now, for the pros and cons (because you know everything has both).
PROS & CONS
Here’s the problem with investing in individual stocks: some of them are just too expensive to buy. You want to make sure your investment portfolio is diversified (aka less risky), and if you spend 70% of your investment money on one or two shares of one company (one share of Berkshire Hathaway has a $214,000 price tag – ONE SHARE), that doesn’t leave you with much left in the bank to cover your arse in case those companies tank. Which can very easily happen in our economy. By consolidating those big-ticket stocks and dividing them up into smaller pieces, mutual funds have the opportunity to allow people like you and me to invest in those high-dollar stock companies without forking over all of our cash. And our homes. And first born child.
For example, let’s look at Netflix (which is trading at roughly $560) and Apple (trading at ~$127). If you had $2,000 to invest, you could roughly get 3 shares of Netflix and 2 shares of Apple, leaving you with a highly undiversified portfolio. Both companies operate in the tech/media sector, so while they may be smart choices, if that market tanks, so does all your retirement money. And you don’t want to take that chance, sister. A mutual fund, on the other hand, may have $100,000 to invest, which means they can buy substantial shares of Netflix and Apple, along with many other stocks and/or bonds in different sectors (like the oil industry or healthcare or financial services) as well. When you buy a share of this fund, then, you will get the advantage of investing in a portion of a share of Netflix or Apple and (hopefully) reaping the benefits. So if the mutual fund as a whole has 5% of their investment in Netflix and Apple, the 5% of the $2,000 you invested in the mutual fund, or $100, will be invested in those as well. This is the reason I love mutual funds so much!
Note I said “less” here and not “none.” You can’t get out of a little homework that easy.
If you invest in individual stocks and individual stocks alone, that takes a lot of precious time to research and monitor – experts say you should spend 2 hours per week per stock that you are researching or currently own. Buy 5 stocks, and your Saturday is blown (bye bye, brunch Bloody Mary!). However, if you invest in a mutual fund that has the same goals as you (i.e. long-term growth), you can cut that time down drastically. To be honest, I spent more time up-front finding a fund I liked and now just look it over once every few months. So see, you can be a savvy investor AND still make it in time for pancakes with the girls ;)
Potential for High Fees
Mutual funds don’t run themselves, people, and those individuals who run them (aka fund managers) aren’t working for free. In fact, many of them like to pay themselves a pretty penny to do so. Hence, enter in fund management fees. Some mutual funds can have extremely high fees, meaning that the company that runs the fund will charge you a specific percentage of the amount you invest in order to cover overhead costs like the fund manager’s pay, etc. BE ON THE LOOKOUT FOR THESE! You never want to fork over a large portion of your investment on fees alone – it just leaves less money to compound and grow! For example, let’s say you choose a fund that has a 2.5% expense ratio. This means that if you invest a $1,000, $25 of that is going straight to the company’s bank account and you will actually only invest $975 into that mutual fund. I know…whomp, whomp, whomp.
Don’t worry, all is not lost. There are funds with extremely low fees (think less than 0.25%) and those are called index funds. Index funds basically mirror the market and follow a specific set of stocks, the most popular of which is the S&P 500. They give you great diversification with low fees, and if you’re just starting out, this is where I would suggest you park your money.
Mutual funds are a great option if you are someone like me – an individual who wants to get in the market and diversify without spending all of their free time trolling Yahoo Finance. Sound like you? I thought so ;) If you have questions, feel free to leave it in the comment section below. Otherwise, stay tuned for my next post where I will FINALLY be showing you how to start building your own portfolio! Ah, exciting!
**Answers: 1) Large-cap/Value, 2) Small-cap/Growth, 3)Mid-cap/Growth