How does a mutual fund work?

Following my article on what a Roth IRA is from last week, Karen wrote in asking a good related question:

“Can you help explain mutual funds? Are they a good investment – better than IRA’s or 401K’s? I realize they may be risky but can you put money into them – watch the money grow and then withdraw the money at any time?“

A mutual fund is basically a big collection of investments. People can choose to invest in the mutual fund, thus owning a slice of all of the investments owned by the mutual fund.

Let’s say, for example, that a mutual fund is made up solely of stocks in Verizon, AT&T, and Sprint – it’s a blue chip telecommunications mutual fund, in other words. The mutual fund is made up of 50% Verizon stocks, 30% AT&T stocks, and 20% Sprint stocks.

You decide to invest in this mutual fund, so you buy a share of it.

On days when the value of AT&T, Sprint, and especially Verizon go up, your mutual fund shares will also go up. If they’re a mixed bag, your mutual fund share will stay roughly even. When the stocks go down, your mutual fund shares go down.

Now, why wouldn’t a person just buy stock in Verizon, AT&T, and Sprint? Well, most mutual funds are much more complex than this example. They’re usually made up of lots of different investments – and not just stocks. There are bond mutual funds and real estate mutual funds and even precious metal mutual funds.

Generally, mutual funds are a very easy way to add diversification to your investments, meaning that they make it really easy to make sure you don’t have all of your eggs in one basket. Each mutual fund has a different philosophy on how they’re going to invest their money – some might buy only big company stocks, while another might just buy technology stocks, while yet another might only buy commercially zoned real estate in cities with a high cost of living. Usually, there’s a person (or team) running the mutual fund that makes decisions about what to buy and when to buy it in accordance with the philosophy of the fund. Because of that, every mutual fund’s holdings are at least somewhat different.

The drawback? Mutual funds charge fees to the people who have invested in them to cover the costs of running the mutual fund. Usually, this is around 1% of the value of the fund per year – but a healthy fund should be returning far better than that. This fee usually just takes the form of a reduction in value of each of your shares, and it’s often done quarterly, so one day you’d just see a 0.25% drop in the value of your shares four times a year and, other than that, it would just follow the value of the investments.

Index funds are what I use to somewhat solve this fee problem. Index funds are a special type of mutual fund. Rather than having someone running the mutual fund and making day-to-day choices about what to invest in, an index fund is run by a simple rule or two. For example, one index fund might just be to own equal amounts of all companies worth more than $1 billion dollars that are considered to be in the telecommunications industry. Because the actual management of this fund is really simple (a computer can basically do it), the fees for an index fund are usually low. However, some people prefer to have a person evaluating their investments rather than trusting a simple set of rules.

When you invest for retirement, using a 401(k) or a Roth IRA, you’ll be offered investment choices, many of which are different flavors of mutual funds. Generally, once you’ve put money into a retirement account, you can easily change what exactly you’re invested in within that account. You can start off with all of your money in one mutual fund within your retirement account, but if you don’t like that one later or if you want to simply move into something more aggressive or something more conservative, you can easily do that.

If you’re just investing on your own, you can open up an ordinary investment account with an investment company and buy mutual funds within that account. Unlike retirement accounts, you can buy and sell mutual funds (or other investments) within an ordinary investment account with basically no restriction, but if you make money, you’ll be facing a tax bill at the end of the year due to the profits you made (just like a savings account, basically).

What do I do? I own some index funds through Vanguard. Since Sarah and I have paid off our house and we’re earning more than we spend, we’re putting the excess into index funds and we’ve been very happy with it, especially compared to having money in a savings account.

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