Welcome to Get Smart about Investing. Over the last 20 years, mutual funds have become very popular. Half of all households in the United States own at least one mutual fund. But despite their widespread use, very few individuals actually understand what a mutual fund really is or the benefits they provide. Basically, a mutual fund is a financial company that takes your money and my money, puts it all together, and hires a team of professional money managers to make the investment decisions. So this is great. Instead of you or I trying to make all of the difficult decisions like what investments to buy, how much to invest, or when to sell, the mutual fund company does that for us. That’s called professional management, which is one of the biggest benefits offered by mutual funds. By using a mutual fund, you’re shifting investing responsibility from yourself to the mutual fund company and taking a less active role in the investment process.
If I ask you to invest money in stocks and bonds tomorrow and you’re like most people, you probably wouldn’t know where to start. Using a mutual fund helps an investor to address the challenges of diversifying a portfolio. Now if you were going to invest $300 or $400 this month, relatively speaking, it’s a small dollar amount and you’re somewhat limited as far as what you could do with it. Sure you could buy a few shares of Coca-Cola stock, or a CD or savings bond at your local bank, but that’s about it. The challenge is if you put all of your money into Coca-Cola stock, your whole fate and fortune is dependent on how this one company does; and we all know about the stories of Enron and WorldCom. The average mutual fund on the other hand, invests in 40 or 50 different investments, all in one fund. That means your money gets spread across many different areas, which gives you exposure to investments that you couldn’t have purchased otherwise and could help increase your returns. It also means that if some of the investments in the mutual fund don’t perform as well, there are other investments to balance things out, which could lower your risk. This is called diversification.We had talked about the importance of it earlier in the program, but again, diversification is just a fancy word for spreading your money in a lot of different areas so that you participate in areas that are doing well and limit yourself in those that aren’t doing as well. Basically, your diversification determines the amount of risk you’re taking and your overall performance. In order to be properly diversified using individual stocks, you would usually have to buy 10 or 20 stocks in each of the different areas. That alone is unrealistic for most individuals. But with a mutual fund, you could simply buy one mutual fund in each area and achieve complete diversification with a lot less effort. So the big advantages of using mutual funds are professional money management and diversification.
I’m Greg McGraime and Now You Know!