What is a Mutual Fund?
Assume you walk into your local bank and said, “I would like to invest money for my future. What do you recommend?” In most cases, they would suggest a series of actively managed mutual funds. They might carry the bank’s brand name, like Wells Fargo or they might be funds created by a different firm.
The first modern mutual fund was launched in the United States in 1924. It provided a way for regular people to invest in the stock market while taking less risk. Before that time, anyone investing in stocks had to buy individual shares from the New York Stock Exchange. This could be risky, and my mother-in-law reminds me of this all the time. “Uncle Harry invested in stocks and he lost everything in 1929.”
Unfortunately for Uncle Harry, he probably didn’t know that he could buy a mutual fund: a collection of several stocks handpicked by a professional fund manager. Instead, Harry likely bought a handful of stocks that he (or his broker) believed would soar. But during the crash of 1929-1932, Harry lost his shirt. I don’t know the details, but the companies he invested in probably went bankrupt.
Mutual funds don’t protect investors from falling markets. But the fund manager at the helm must ensure a minimum level of diversification. In other words, he or she can’t stockpile everything into just four of five stocks. That’s why, if you buy a mutual fund, you indirectly own shares in dozens or even hundreds of stocks. That would have given Uncle Harry decent odds of recovering his initial investment, and then earning a profit…if he were patient.
The fund manager also trades shares within the fund, trying to buy what’s hot while avoiding or selling what’s not. In other words, owning an actively managed mutual fund is a way to have a professional money manager picking stocks for you.
Such mutual funds are categorized into different asset classes and sectors. For example, assume a bank or investment firm launches a new fund. They might tell Tony, the handsome chap who’s hired to run the fund, “Tony, your job is to only buy stocks of large American companies. We’re going to call it, the Super U.S. Large-Cap fund.”
Assume the mutual fund company also hired a woman named Tina. The firm tells her, “Tina, you’re only going to buy stocks from emerging market countries, like India, Brazil, Russia, China, Thailand etc. We’ll call this the Spectacular Emerging Market fund.
These are just two common fund categories, among plenty. Others include funds that focus on developed market international shares, small company international shares and small company US shares. Plenty of funds are also categorized by whether the fund manager’s mission is to buy growth stocks or value stocks. Growth stocks are companies that are expected to grow fast corporate profits. Value stocks are those that are currently priced at low levels, relative to the corporate earnings of the companies themselves.
Other mutual funds focus on bonds, or a mix of stocks and bonds. If they are actively managed, a trader (like Tony or Tina) trades such stocks or bonds, hoping to make money on behalf of the investor.
Indexed mutual funds, however, are different. As mentioned in this article, they don’t have fund managers that actively trade in and out of stocks and/or bonds in an attempt to squeeze out higher profits. And because indexed mutual funds don’t require an active manager, they cost less. On average, they also perform much better than actively managed mutual funds.
To provide the highest statistical odds of investment success, it’s better to invest in indexed mutual funds, compared to actively managed mutual funds.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas
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