Mutual Funds for Dummies

This article, so insensitively named Mutual Funds for Dummies, completes our "dummies" series in this section of the website.  We have already covered topics such as stocks and investing, and are rounding out this section with this article on mutual funds.

We're going to follow the same format as our prior articles of this type, and offer just enough information to get started investing in mutual funds.  By covering the basics, individuals that are new to the stock, bond, and mutual fund market should be more comfortable investing their money.

Why Mutual Funds for Dummies?

It's possible to draw two conclusions from the fact that so many people look for simplified explanations:

  • They're busy doing what they do best, and are looking to reduce the total amount of information they need to absorb.  We live in the information age, and the "dummies" approach helps to distill information down into more manageable chunks.
  • Investors recognize the value of mutual funds, and want to quickly understand how to get started in this area.

Risk and Mutual Funds

Investing in mutual funds is fairly easy; in fact, it is much easier than investing in stocks.  When purchasing shares in a mutual fund, an investor is really purchasing a portfolio of stocks and / or bonds, and that mix lowers the overall risk of their investment.  That's because whenever someone buys an individual stock in a company, they're taking on two kinds of risk.

  • The first form of risk is associated with a single company. For example, the company can have operating problems and miss their earnings per share targets.  The company's management team may also fail to capitalize on an opportunity.  These missteps will cause the company's stock price to decline.
  • The second risk has to do with macroeconomic factors.  For example, an industry could suffer a downturn in future outlook, or economic factors might affect the cost to borrow money, and stocks could enter a bear market.

Mutual funds allow investors to eliminate most of the risk associated with individual stocks through the portfolio concept.  By holding more stocks or securities in a portfolio, it's possible to lower the impact of a single company underperforming relative to expectations.

Researching Funds

Unfortunately, even "dummies" need to do their research.  If there is one shortcut that should not be avoided, it is researching funds.  Fortunately, we have three articles that can help jump start this area:

  • Mutual Fund Ratings:  discusses the most commonly used, and arguably the most famous, rating system for mutual funds:  The Morningstar system.
  • Mutual Fund Research:  a good place to get a better feel for the wide range of mutual funds available to investors.
  • Mutual Fund Performance:  finally, this article discusses how to go about determining a mutual fund's performance, and what to look out for when evaluating a fund.

Fees and Loads

The price of one share of a mutual fund is usually quoted in terms of NAV, or Net Asset Value.  This is a number that can be found online or in the newspaper. Investing in mutual funds is fairly easy since most brokerage houses allow investors to add money through automatic withdrawals from a bank account.  This can help build up an investment portfolio over time, which is a less painful approach.

Perhaps the most important short-term consideration is the fund's fee structure.  This is discussed in more detail in No-Load Mutual Funds and Mutual Fund Loads.  If the mutual fund carries an upfront fee of 5.0%, the investor is starting out with a fairly significant loss on their investment.  In almost all situations, no-load funds are a better choice. This is especially true in the short term.  In fact, research demonstrates that no-load funds outperform funds that charge a load.

Finally, mutual funds also charge management fees, which are used to pay the trading costs and management salaries of the individuals running the fund.  Smart investors will want to make sure the fund fees are low.  As a guide, a good index fund will have fees in the 0.50% range, while a domestic stock fund might be around 1.20%.  Index funds are not actively traded, while domestic stock funds can incur significant trading costs.  These two values provide a good benchmark for the range of mutual fund fees that are acceptable.

About the Author - Mutual Funds for Dummies (Last Reviewed on June 1, 2016)