What Are Mutual Funds?

After you pick your Order of Operations and move money into an investment account, you will need to decide what to do with your money. Investment accounts themselves are just holding vehicles.  The money you transfer to those accounts is not invested in anything and held as cash or a cash equivalent.  While you might have made all the right decisions regarding the Order of Operations, if you don’t actually invest the money then you just have cash sitting in some fancy investment account.  Today we will look at one of the most common investment products and answer the question … What are mutual funds?

What are Mutual Funds?

The most common type of investing regardless of the type of account is done with mutual funds or Exchange Traded Funds (ETFs).  For now, let’s assume these are the equivalent and just refer to them as mutual funds.  Now you may ask what are mutual funds?  It is a group of stocks that are picked by a manager to create a bundle for a certain type of investment class.

Let’s do an example … say you wanted to invest heavily in Tech, you could go out and buy Google, Apple, Microsoft and Intel individually with a 25% allocation in each because that’s what you think is best.  Now there are several things wrong with this way of investing:

  1. Why Tech? It’s done great recently but will it continue to do so going forward?
  2. Why these Four? There are plenty of tech companies out there and what makes these a better investment than the others.
  3. Why that allocation?  Is Google equivalent to Intel in growth potential going forward?

The purpose of this example is to say Don’t Do It! You likely do not have the information or understanding to make any of these decisions.  Unless you are a full-time investment banker and literally call into all the shareholder conference calls for these companies, I don’t think this is how you should play the game.  This is where mutual funds come to the rescue.

Jack Bogle – Do I need to say more?

The modern-day mutual fund was started in 1924 and this option has become very popular over the past 20-30 years.  Jack Bogle made them popular and accessible to the masses when he started Vanguard in 1974.  Some would call him the pioneer for low-cost index mutual funds.

What is an index fund? This is a metric that looks at different slices of the stock market, for example, the S&P 500 is based on 500 publically traded companies.  An S&P 500 index fund will create a group of stocks that mimic the S&P 500 index so essentially you will get exposure to 500 companies at once. Common index funds are based on the Dow Jones, Nasdaq, Russell 1000 etc.  You will commonly see these on the evening news or in the corner on finance websites.  It gives you an idea of how the stock market is doing but in a very general aspect.

Now there are mutual funds for every aspect of the economy (tech, energy, healthcare, commodities etc.) but we will just focus on general index funds for this lesson.

Cost of Mutual Funds

Everything has a cost in life and mutual funds are no exception.  The investment company and fund manager(s) all want to be paid to bring you this amazing investment tool.  The fee or cost of a mutual fund is usually referred to as the expense ratio. These can range from multiple percentage points to fractional percentages and if you understood the impact of fees then you will agree that lower the better.

Over the years the cost of mutual funds has gone down dramatically with some people debating if they will go down all the way to Zero.

401(k) Sneak Peak

When looking at different investment options I always look at the expense ratio first. There are an endless number of data points you can look at but the cost is the only thing that is guaranteed going forward.  The rest are usually historical and really shouldn’t be used to predict the future.

The best place to start with mutual funds is your 401(k) at work.  You already have money that is being invested and it usually requires a little bit of tweaking to get you in a better position. Figure out how to log into your account and look at where the money is invested by default and browse the other options available.  I think you will start to see a stark difference in the expense ratios among the different mutual funds and coincidentally your default option is likely to be the most expensive.

Now you might love the place you work and believe they are doing the best thing for their employees but when it comes to 401(k) plans they will probably pass the cost on to you to save a buck.  The investment firm they partner with will charge them a lower rate if they pick a more expensive default option which is essentially passing the cost on to you. They also rely on the fact that most employees don’t log into their account to adjust their investment.  They know that they will collect more in fees and cut your employer a deal. Don’t fall for the trap and optimize your accounts with low-cost index funds.

Which mutual funds to pick?

Once you calm down from your anger at being screwed by your work 401(k) you will then look at the long list of options and want to decide which mutual funds to pick.  I wish this was a simple answer but it requires a little more discussion about Risk Tolerance and Asset Allocation which we will cover in the next post.  Essentially you want to maximize returns and minimize risk and find the point where any more risk would reduce your returns or any less risk would leave money on the table.

This will be Lesson 6 in our Financial Planning 101 Series and next time we will about the Efficient Frontier where we talk about risk, return and asset allocations.

–Dr.Linus

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