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Mutual Funds 101: Demystifying Investment

23 Mar

Definition: Mutual funds are an investment strategy which pools money from many, many different investors to construct a portfolio of stocks, bonds, real estate, and/or other securities, depending on its charter. Each investor in the fund gets a slice of the total pie.

What are the perks to investing in mutual funds? Diversification, one of the basic rules of investing in general is varying your portfolio. Diversification is a technique that mixes a wide variety of investments within a portfolio. This is meant to yield higher returns for lower risks because while you might take hits in some parts of your portfolio, the positives—if chosen correctly—will offset those.

“Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction.” – Investopedia

Another pro to the mutual funds game are the relatively low minimum investment amounts. Some you can join with just a few hundred dollars, spreading the risk across to more people, allowing investors to make some riskier decisions with higher potential returns.

So, there’s active management and passive management.

Active Management:

Is the actual practice of picking your stocks and market timing to pick securities which will beat out the market. This is the most common type of management. The high volume of trading results in higher expenses.

Passive Management:

These funds do not attempt to meet the market, but to match the risk with the return of the stock market. These usually track a market index such as the S&P 500. Those that follow this index, for example, tend to hold the stocks within the S&P 500.

Advantages:

1. The percentage of fees paid to the company to manage and operate the fund is less in passive funds than in active funds.
2. Lower mutual fund capital gains distributions.

A good analogy I found regarding the difference between active and passive investment management is the distinction between the actions of one individual vs. the actions of the group as a whole. “Active investment is like trying to bet on who will win the Super Bowl, while passive investing would be the ability to profit as all the NFL teams collectively made money on ticket and merchandise sales.”

Now, let’s move on. There are two different types of funds I’d like to talk about today: stock (equity) funds and bond funds.

Equity Funds:

Mutual fund that invests primarily in stocks; equity funds typically have their own distinct styles. Some focus on the different sizes of companies such as the size of businesses (small-cap versus large-cap) and their geography while others might buy shares within particular sectors such as health care or entertainment. These are sometimes referred to as “specialty stocks.”

Bond Funds:

Bond funds come in many different colors as well. There are safe investments with lower yields such as government bond funds, high-risk (and hopefully high-yield) bond funds. These can get extremely complicated, but if this is something you’re interested in, click here to be taken to a page which does an adequate job of explaining what type of things to look for to determine whether or not these bonds will be safe investments.

But don’t forget to pay your taxes. Regardless of whether or not you sell your fund shares, if you’re raking in money, you could be hit by a pretty hefty tax for both your dividends and capital gains. That sounds pretty painful doesn’t it? What if I told you that you’re stuck paying taxes even when your funds have declined in value? Well, the truth of it is that you’re going to end up paying taxes regardless of how your fund performs, but since there’s not much to be done about that, my only advice here is to be aware of this undeniable truth. According to CNN Money, the most tax-efficient funds avoid rapid trading.

CNN Money also advises investors to not chase winners and to look for consistency in the long-term rather than those particular funds which might be ranked highly at this one point in time. Investors are also told to not be too quick to dump underperforming funds as any fund can have an off year. Just make calculated decisions, watch for a pattern, and come up with a few forecasts.

A VERY SUCCINT DISCUSSION OF A FEW DIFFERENT TYPES OF STOCK FUNDS:

1. Value funds: look for cheap stocks. Either big companies/corporations which have been suffering in recent days and are selling shares at lower, discounted prices, or smaller companies which have been beaten out by competition or other investors but could have brighter days ahead.
2. Growth funds: varies depending on how aggressive the investor might be. Tend to favor established names, but look for rapidly growing companies as well. Good for long-term investors who should build around such funds in their portfolios.
3. Sector funds: as I mentioned before, these investors focus on particular sectors such as health care, entertainment, technology, etc. Just be aware that entire sectors are also liable to head south.

A VERY SUCCINT DISCUSSION OF A FEW DIFFERENT TYPES OF BOND FUNDS:

1. U.S. government bond funds: bonds issued by the U.S. Treasury or federal government agencies. Seen as extremely safe, so you shouldn’t expect extremely high returns with these. The longer you hold on to the bonds, the higher your yield. So if you’re comfortable with sitting on them—they fluctuate with the interest rate—then you probably might as well be in it for the long run.
2. Corporate bond funds: bonds issued by corporations. Each corporation has a credit quality issued to them, the highest being AAA. The longer the average maturity, the greater the volatility.
3. High-yield bond funds: focus on smaller and/or riskier companies. Expect a few defaults here and there. Shouldn’t be a huge proportion of your portfolio unless you’re comfortable taking risks for the chance of seeing higher returns.
4. Municipal bond funds: issued by cities, states, and other government localities. Are tax-exempt. Don’t have much more to say about these myself, so just click through the link if you’re interested in safe, low-yield prospects.

Now that we’ve hopefully demystified mutual funds (or at least opened a few doors for you) you might be wondering why exactly some active funds underperform. The costs of research, administration, management salaries, and other expenses are borne by the shareholders.

If you’re new to the game and want to try to get your own slice of the market, explore U.S. Securities and Exchange Commissions’ page to get started. Look for more posts on the subject of investing in the days and weeks to come!

Sources:CNN Money, Investopedia & About.com

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Posted by on March 23, 2011 in Business/Technology

 

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