March 14, 2012

Mutual Funds Explained for Dummies

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Do you know what a mutual fund is?  I think most people understand the concept, at least vaguely.  It has occurred to me that some do not.  I think back to when I first really understood mutual fund investing.  It was sometime in my early 20’s when I read Dave Ramsey’s first book, Financial Peace.  Since then, the concept and the way it works has always made perfect sense to me.  It’s kind of like learning multiplication in grade school.  Once you memorize all the different multiplication scenarios with numbers one through twelve, you never forget.  When you need to multiply 7 times 9 for whatever reason, you don’t even have to think to come up with 63.  The answer is just there in your brain.  The same goes for mutual fund investing.  Once you understand how it works, you don’t have to think about it anymore.  You just do it.  If you don’t quite understand mutual fund investing, this post is for you.  Keep reading, as I will attempt to explain it as simply as possible.


A Mutual Gambling StrategyPoker

Let’s say a group of four friends makes a monthly trip to a casino.  They all enjoy different casino games.  Three of the friends risk their money in games where they play against the house, such as slots, blackjack, craps and roulette.  The fourth friend usually sticks to the poker room where he plays against other patrons.  Once in awhile, one of the three will hit a big win.  But most of the time, they all lose their money.  The fourth friend, the one who usually plays poker, consistently wins.  Sometime he wins a lot, sometime only a little, but he rarely loses all of his money.

One day, the group comes up with a plan.  Instead of playing separate games with their individual funds they decide to pool all of their money together and give it to the poker player.  In other words, they are going to mutually fund their casino trip.  Depending on the percentage of money that each puts in, they will divide the winnings (or remaining money) accordingly.  For example, they have a total amount of $1,000.  Three of the friends each contributed $200 and the fourth contributed $400.  The first three friends in this example will each get 20% of the remaining money, while the fourth will get 40%.  Whether money is won or lost, they plan to divide it up fairly this way.  By giving the money to the poker player who is able to win consistently, they all end up ahead.  This method is not as fun or exciting, but everybody is happy to walk out of the casino with money in their pockets.

Mutual Fund Investing
If you can understand how those four friends were able to take advantage of mutually funding their gambling money, you can understand how mutual fund investing in stocks works.  It is very similar.

Investing in single stocks can be compared to when the four friends played separate games with their individual funds.  Investing in single stocks is a single person buying shares of stock in one company.  This method is very risky and more volatile.  Sometimes you can make a lot of money very quickly by investing in single stocks.  Just the same, you can easily lose a great deal of money by investing this way.

Mutual fund investing is just that, an investment that is mutually funded.  The money that you put in to mutual fund investments is represented by shares.  These shares represent your percentage of the funds invested.  The investment part of the mutual fund is handled usually by a group of investors.  They invest the funds into not one, but several different stocks or other investments.  This is their job.  It is what they do all day every day.  They are the experts, and they would be compared to the poker player in the example written above.  They are able to consistently gain money by putting it into investments that go up in value.

There are several different types of mutual funds offered by several different companies, or fund families.  Some mutual funds are very conservative and offer lower but more stable returns.  Other mutual funds are invested more aggressively.  These are usually volatile, and go up and down in value, but offer greater long term returns.  Some mutual funds invest only in large companies.  Some invest in small ones.  Some mutual funds invest in international stocks, while other invest in bonds or precious metals.

If you have a 401k through your employer, you probably have money invested in mutual funds.  Whether you knew it or not, you are mutually funding an investment that is managed by somebody else.  Many believe mutual fund investing to be the safest and most secure way to invest in the stock market.

Readers:  Did you understand mutual fund investing before reading this?  If not, was this helpful?  Do you have money invested in mutual funds?


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