Definition: A corporation that does not produce goods or services of its own, but instead carefully invests its shareholders’ money in the stocks and/or bonds of corporations that do.Example: 100,000 people each buy 200 shares of Ace Stock Mutual Fund, paying $50 per share, as follows:
200 shares * $50 per share = $10,000 per person
Now, let’s extend this out to the 100,000 investors around the U.S. who Ace convinced to invest:
$10,000 per investor * 100,000 investors equals = $1,000,000,000, or $1 billion
Ace received a total of $1 billion of new investors’ money. It takes this money and buys shares of 100 corporations it believes are going to do well in the future. The group of investments is known as its holdings. A year later, the value of the holdings as a group has risen to $1.1 billion. The $100 million gain is 1/10th, or 10% of the $1 billion invested. While not offering a unique product or service of its own, over the course of a year Ace has earned its shareholders 10%.
Investeach explains: You may have noted that Ace actually does have a unique service to offer: skill in selecting the right corporations at the right time! Having skilled financial professionals investing your money is one of the supposed advantages of mutual funds.
The reason we say supposed is that over extended periods of time like a decade or more, the majority of fund managers do not beat the performance of the overall stock market. While 10% in our above example appears solid, would you feel the same way if you learned that the value of stocks overall rose 12% over the same year?
Another point to keep in mind is that professional managers don’t work for nothing! They charge a management fee for their services, and the fee is subtracted each year from the fund’s holdings. In our above example, if it cost $10 million to “run” the fund, that is 1% of the $1 billion managed. For fund shareholders, the rate of return is 10% minus the 1% management fee, which equals 9%.
A second reason why mutual funds are popular with investors is that they can achieve diversification. Because it receives money from many investors, Ace can efficiently make a single purchase of each corporation’s shares for all of its shareholders. Contrast that with what an individual can do on his or her own. A low commission for purchasing any number shares of one corporation is $5. When you make purchases using a broker such as Charles Schwab or TD Ameritrade, you do so one corporation at a time. For an individual to purchase shares of 100 different corporations would cost $5 * 100, or $500. That would result in a loss of $10,000 each person wishes to invest!
The other problem with an individual investor trying to achieve significant diversification is that after purchasing so many corporations, the investor has to stay on top of what is happening with every one of them!
There are thousands of mutual funds available to meet different investing objectives. For example, retirees may want to invest in income funds, those whose holdings make steady payments they can live on. Younger investors may want to grow their wealth by investing in funds which pick investments that have a higher risk but also a greater chance of rising in value (known as growth funds).
Finally, in order to achieve the various objectives (two of which we just discussed), some funds invest only in stocks (known as stock funds or equity funds), some only in bonds (known as bond funds), and some a combination of both (known as blend funds or hybrid funds).
Riddle me this:
1. While mutual funds appear to piggyback off the success of other corporations, there is a unique service that they offer. What is it?
2. Why are many people not impressed by the service you just identified?
3. What name do we give to the stocks and/or bonds a fund currently owns?
4. What name do we give to the amount of money the professionals managing the fund charge each year for their services?
5. Who pays this fee?
6. Identify a second advantage that mutual funds offer which cannot be easily achieved by individual investors.
7. Why is it so expensive for individuals to achieve diversification on their own?
8. Identify two investors who, because of the different places they are in their lives, have different investing objectives.
9. Identify which type of fund makes regular payments to its shareholders.
10. How is investing in a growth fund a way to possibly achieve significant wealth accumulation with less risk than purchasing a few growth stocks on your own?
11. What two names do we give to funds which invest in both stocks and bonds?