I run into this all the time. Lots of people have them and there are literally thousands of them available, but most people are not really sure what they are. Part of that is because Mutual Funds come in all kinds of flavors, and types. There are now even ones called Exchange Traded Funds (ETF’s) that you can buy and sell on the stock exchange. Mutual Funds are a relatively SAFE investment. They tend to not go down fast, nor do they go up fast. They are designed to grow over the long term. (10 plus years)
There are different types of funds for different risk tolerances. One of the first rules of investing is that high returns are accompanied by High Risk. Low returns are accompanied by Low risk. A good Financial Planner will ask you questions to determine your “Risk Tolerance”. Most Mutual Fund portfolios are a mix of low to high Risk. The word Aggressive is often used instead of High Risk as it sounds better.
There are a few basics that you need to know about Mutual Funds. Let’s start with what they are. Diversification is one of the key words when it comes to investing. Diversification is a fancy word for not putting all your eggs in one basket. When you buy 100 shares of Ford Motor you are committed to the ups and downs of just Ford Motor. Diversification would like you to have stock in Ford, Fiat, Toyota, Honda, and GM. The theory is, that if one goes down, one of the others will go up. Having more than one stock will help keep your investment from moving to extremes. It is a very good idea. That is the basis of a Mutual Fund. Diversification.
You could do this yourself by buying stocks in all of those different companies. But that would be darn expensive. To buy a reasonable amount of stock in each of those companies would require several thousand dollars. Stocks are normally sold in lots of 100 shares. Today Ford Motors sell at $10.46 a share. So, to buy 100 shares would cost $1046.00. (GM @ $38.50, Toyota @ $ 68.51)
This is pretty tough when you want to invest $50.00 a month. This is where the “Mutual” part comes in. Say there are 100 people who put $50.00 a month each into a Fund. That is $5000.00 a month combined. With that money, each month, the “Fund” buys a different company’s stock. In several months The Fund has a diversified bunch of stocks. The value of the Fund is divided between each of the people who invested in the fund based on how much money they put in. Say the Fund is worth $200,000.00 and 100 people all put in the same amount of money. So, everyone owns 100th of the value or $2,000.00 each. In reality every contributes a different amount.
Mutual Funds are made up of Units. Usually a few million per Fund. The value of the fund is the total value of whatever the Fund is invested in, divided by the number of units. The Fund is worth $100,000,000.00 and has 10 million Units. Each unit would be worth $10.00. The value of a Unit can (and usually does) change daily. Because it is the value of what all the units are invested in, that establishes the value of the whole Fund and then, each unit.
Mutual Funds, unlike stocks, can be bought in less than whole units. You can not buy half a stock. But you can buy .356 of a Mutual Fund unit. This fictionalization is what allows you to invest by the dollar amount, rather than the number of shares. If you invest $50.00 in a Fund where the unit cost is $8.45 you would get 5.917 Units.
When the underlying investments of the fund pay out interest or dividends, this money comes back to the Fund holders. Funds very seldom give back cash. But they will give you more units. Let’s say a fund gets money coming in that amounts to $10.00 a unit. You don’t get the $10.00 but (from the previous example) you would get 1.183 additional units. ($10.00 divided by $8.45). That is one of the key things you want to look for in a Mutual Fund. How often do they distribute income to the fund? Monthly is best, Quarterly is next and Yearly is last.
Each Fund is looked after by a Fund Manager. Their job is to make sure the Fund makes money and tries not to lose money. But just like stocks, Fund Unit values fluctuate. You also have to realize that the Fund has to pay the manager and all the Financial planners as well. It also has to pay the commissions on any trades that the Fund makes. Each Fund has a Management Expense Ratio. (MER) This is money that comes out of the Fund. The MER is money that you don’t get. The lower the MER for a fund the better for you. If the Fund made 2% but the MER is 3% you lost 1%. Asking a Financial Planner how the MER affects the unit price, is a very important question to ask.
The next thing you need to ask about are the fees or the LOAD. There are No Load, Front End Load, and Back End Loads. There are some other fancy terms out there as well. Make your rep explain them to you. As a general rule of thumb, No Loads are good, but often come with higher MERs. (expenses have to be paid somehow.) Front end loads are not as bad as they sound. These are charged on the amount you are putting in today. If you put in $50.00 the fee is on the $50.00. Some companies will give back part of the fees over time.
Back End Loads are not as good for you, depending on how long the money has been in the fund. The fee is now charged on the value you take out. You buy Mutual funds hoping that they will earn you more money. Back End Loads will charge you a fee on not just what you put in but also on the money that the Fund made. It is worth noting that a lot of Funds with Back End Loads, are a decreasing expense over time. If you leave the money in the Fund for more than 7 to 10 years, there is a good chance the fee will be gone. But not all Funds are the same so ASK.
If you put in $1200.00 and it grows by 5% each year for 5 years, you would have $1,531.00 after 5 years. If you took that money out, with a Back End Load, you pay your fees on the $1,531.00. If it was a Front End Load, you would have paid on only the $1,200.00. If you leave it in there for 20 years there may not be any fee at all. You need to know.
They will also like to show you graphs and charts about the past performance of the fund. The main one they like to use is the past 10 years chart. Realize however, that “Past performance is no indication of Future performance.” This chart is really only valuable if you have been in the Fund for the last 10 years.
Mutual Funds are a great way to make more than a Savings Account pays. But like any investment, you need to understand how it works and how much it costs you. You should also track your Funds at least monthly. (I recommend weekly) Also most Financial Planners will only show you Funds from their company. Every company has at least one good Fund. But not all of their Funds are the best. Try and find a Financial Planner that has more than one company to choose Funds from.
Lastly you should deal with a Planner that reviews your investments with you every 6 months. The world changes and those changes affect each Fund differently.
To put it in a nutshell, use a good Financial Planner, find a fund with the lowest MER, that pays out monthly. The younger you are the more you should have in Aggressive funds, the older you are, the more you need Safe Funds.