Welcome back beloved reader. Now that we have established what stock is, and how it gains value we are ready to talk about Mutual Funds. As always this blog is for entertainment purposes and is not intended as investment advice. Consult a licensed fiduciary adviser for more information.
In my last post we established that diversifying your portfolio diffuses risk. A mutual fund is pre-diversified in a sense. The money invested into the fund is split up into many different investments. Mutual funds typically hold shares of stock in different companies, bonds and even cash. Instead of having to buy a lot of individual shares to round out the ratios in my portfolio I can just buy one share of the mutual fund that is already diversified into many different companies and/or investment types.
How do the funds decide the product mix? Some funds are actively managed, this means that you have an expert picking investments in response to trends in the market. Some funds have a more "set it and forget it" strategy where their holdings don't change as often. It sounds like having an active manager would be way better right? Watch out for higher fees in the actively managed fund; Stock market experts don't work for free.
Typically the mutual fund will have some sort of theme or investment strategy to guide the product mix within the fund. For example it might be centered around an industry like healthcare stocks or technology stocks. A fund might choose based on the size of the companies, large cap stock vs small cap stock. A fund might focus on international investments or domestic investments. Some funds even are themed around the year that you want the fund to be at it's peak, typically the date you want to retire. Index funds try to spread out the love over a whole economy.
You have heard of the major stock indices. Nasdaq, the Dow the S&P 500. They are all over the news, but how do they actually work? Essentially they are intended to be a representative sample of the whole economy. They select individual companies in different sectors across a wide range of industries. The idea is that the number could give you an idea of how the domestic economy was doing overall. Think of it like a public opinion poll. You wouldn't call every person in America to find out who they wanted to vote for right? Polling companies instead try to pick a representative sample by polling people in targeted demographics to simulate the ratio of the entire population. So the index is kind of like a public opinion poll for the stock market. Remember that in the world of stocks opinions equate to market value.
An index fund essentially copies the product mix that the stock index uses to poll the economy. Someone already did the research to come up with a representative sample; why not put it to good use? Since the heavy lifting of picking the product mix has already been done these funds tend to have low fee structures. Because the holdings of the mutual fund are so well diversified the returns tend to be fairly stable in the long run.
Many retirement accounts use mutual funds as the investment vehicle. When selecting the funds that you want to ride into your golden years look at the long term performance of the funds. Although past performance is no guarantee of future value, it is often used as an indicator of a well proportioned fund. Many investors choose the risk in their retirement portfolio based on how long they have until retirement. Longer time frames typically equate to a higher risk tolerance.
One way to lower the risk in a mutual fund portfolio is by using Bonds. We will explore this topic more in our next post. Until then dear reader stay sane and take some personal responsibility for your finances.
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