For many people, mutual funds serve as an introduction to investing. But many of my new clients and prospective clients have confessed that they’ve bought mutual funds without even having an introduction to what mutual funds actually are.
In a nutshell, mutual funds enable you to purchase stocks, bonds, and other assets by pooling cash with other investors. Mutual funds are popular, especially among new or casual investors, because it’s a relatively inexpensive and easy way to diversify your portfolio and hedge against losses while reaping market gains.
But just because mutual funds are a somewhat simpler path to investing than other vehicles, doesn’t mean you shouldn’t do your research or be strategic about your mutual fund investment plan. The more you know about mutual funds, the better choices you can make. But if you’re not a financial geek like I am, I’m betting you’d like to learn about mutual fund investing in plain English like my clients.
What is a mutual fund?
A mutual fund is a portfolio of assets, such as stocks and bonds, that are managed by professionals. Large groups of securities are purchased with money pooled from groups of investors who buy into the fund.
Rather than owning individual company shares, the mutual fund investors own shares in the mutual fund company, which is in the business of buying shares in other companies, securities, or government bonds. So they do not own stock directly but rather share in the profits or losses of the mutual fund’s overall holdings.
When I first started teaching this concept to clients, I could tell that my explanation wasn’t sinking in. So I began breaking the concepts down even further and using analogies to clarify.
If you’re not familiar with some of the terms I’ve already used, you’re not alone. So I will help you out and expand from there.
Stocks, which are also referred to as equities, represent ownership. If you own a share of Google stock, for example, you are a part-owner of Google and you are buying that stock because you want to participate in the company’s success.
Bonds are a kind of debt issued by companies looking for capital. A bond is really just a loan with lots of crazy terms. Simply put, when you buy bonds, you are the banker lending money to the company. If you were to buy a Google bond, for example, you agree to lend the company your money, and they, in turn, agree to pay you back with interest.
Now that you’re more familiar with what stocks and bonds are, let’s dive into some analogies I use to help you better understand how mutual funds work.
How Mutual Funds are Like Cookie Jars
I grew up in a true American blended family. I was an only child, my dad married into a family with four boys, and then my dad and stepmother had a daughter. With so many growing kids in the house, there were rarely any leftovers after dinner. We would come home hungry the next day, as every kid does, looking for something to eat. Since there were usually no leftovers in the fridge and we wanted something easy, we tended to reach for the cookie jar on the counter.
Remember the cookie jar?
Everyone had one, but in our cookie jar, you never quite knew what you were going to get. One week you might reach in and get an Oreo cookie, the next week a Nutter Butter or Chips Ahoy! And if we were really lucky, we’d find homemade chocolate chip cookies. My stepmother, Linda, did an amazing job of keeping us fed and did it on a budget, so whatever was on sale made it into the cookie jar.
That cookie jar was like a mutual fund.
Let’s call it a Tech Equity Fund – meaning it’s made up of stocks of tech companies. In my cookie jar analogy, the Oreo represents Google, the Nutter Butter represents Apple, the Chips Ahoy represents Facebook, and the homemade chocolate chips represent Microsoft.
When you own the cookie jar, you own a little piece of each cookie or in the case of the Tech Equity Fund – you own a little share of each of those tech companies. This is why I compare mutual funds to cookie jars.
But there are all kinds of shapes and sizes of cookie jars, just like there are all kinds of styles and sizes of funds. It all depends upon what type of cookies (i.e., stocks) they hold.
Next, I will use an analogy about high school kids to explain the basics of funds in the market.
How Mutual Funds are Like High School Kids
Remember high school? Whether you would prefer to forget it or you’d love to go back — either way, you learned some valuable lessons about mutual funds without even realizing it. Let me explain.
The market capitalization of a company is the market value of its outstanding shares. Smaller companies are more volatile; and although you may get a larger return on your investment, investing in small-cap companies opens you up to more risk. Large-cap funds are less risky, but with relatively lower potential gain.
Freshmen are like Small-Cap Stocks.
Remember being a freshman in high school? It was a very volatile time. You were not yet as established as the upperclassmen and could end up going the wrong way. Small-cap funds are like freshmen because they are not as established; they could take a positive route and grow all the way to becoming a successful senior or they could fail and drop out.
Sophomores are like Mid-Cap funds.
When you were a sophomore, you had made it through the volatility of being a freshman and were getting into the groove of what it really took to navigate high school. Mid-cap funds are like sophomores because they are no longer volatile little pimple-faced freshmen; they are a bit more mature and a bit less risky.
Juniors are like Large-Cap funds.
As a junior in high school, you had already established yourself. You had made it far enough that you were on the road to becoming a senior. Betting on a solid junior who has his head on straight is normally a bit less risky than choosing a sophomore or freshman.
Seniors are like Mega-Cap funds.
As we all learned, seniors rule the school. They have it all figured out better than their younger counterparts and know where they are going — on to college or another path. The same holds true, in theory, for the mega-cap companies.
What about the foreign exchange students? They represent the international funds, which come from all over the world and could be a mix of Freshman, Sophomores, Juniors, and Seniors. They can even be combined into an international fund or specific country fund.
Mutual Fund Investing
Now that you know more about what comprises a mutual fund and the different types of funds, you can better understand mutual fund investing. Pull out your statements and take a look at your investment portfolio. What’s in your cookie jars? What kind of cookie jars do you have? Do you notice a mix of companies within an industry? A mix of industries? Are they all mid-cap? What’s under the lid?
If you need help mastering your finances so that you can create the freedom to build the life you want, you can email me at email@example.com or schedule a consultation appointment.
Gabe Nelson, CFP®, is the principal and founder Gabe Nelson Financial, Inc. (GNF) is a Registered Investment Advisory firm based in Sioux Falls, SD. GNF offers fee-based financial planning and investment advisory services to solopreneurs and self-employed professionals. Clients receive personal attention from a financial planner dedicated to helping them reach short and long term financial goals with specialized insight into the particular challenges and opportunities that arise in entrepreneurship. Gabe can be reached at 605.553.9180, via email at firstname.lastname@example.org, or on the web at gabenelsonfinancial.com.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.