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Mutual Fund Basic Training


First of all, let’s talk about what a mutual fund is. A mutual fund is nothing more than an arrangement in which many investors pool their funds and hire a professional money manager to buy securities for them. So what’s a “security?” For the purposes of this discussion, it’s any asset bought and sold over the world’s securities exchanges. Most of the time, when people say “securities,” they are referring to stocks and bonds, as well as shares of mutual funds themselves that own them. But the term securities can also include commodities, options, futures, and less well-known investment vehicles such as convertible bonds, preferred stock, master limited partnerships, and others. 99 percent of the time, however, commonly-traded mutual funds concentrate on stocks and bonds.

Stocks

So what’s a “stock?” It’s simply a small piece of ownership in a corporation. That’s it. When you own a share of common stock, you are a part owner of a corporation. You are entitled to one vote per share in naming the board of directors, which hires and fires executives and looks out for the interests of shareholders. You are also entitled to your share of any dividends – a distribution of profits to shareholders – that the company issues.

Stockholders can make money in two ways: From dividends, or they can make money when the stock price goes up, by selling stocks for more than they paid for their shares. Not all stocks pay dividends. Stocks derive their value, ultimately, from the dividends they are expected to issue in the future.

Another word for stocks is “equities,” and a share of stock represents equity in a company the same way the term “equity” represents your ownership in your house.

Bonds

A bond, quite literally, is an IOU. When a company or government agency wants to borrow money, it will issue a bond to investors. The company will repay the investors with regular interest payments – every month, every six months, or every year, typically. At the end of the term, the company will repay the principal of the loan.

Bond investors also make money in two ways: From the regular interest payments the bond issuer sends, and the potential for an increase in the bond price itself. If interest rates rise, bond prices falls. If interest rates fall, bond prices rise. Generally, the dollar value of the dividend payment, or the coupon rate, stays the same.

Bonds tend to be more stable in value than stocks, though you can lose money in both if things don’t go your way. Neither dividends nor profits are guaranteed, though a bond issuer can’t miss payments without going into default. Bankruptcy typically follows.

Types of Funds

Obviously, there are stock funds and there are bond funds. Stock funds that concentrate on companies that actually pay dividends may be referred to as “growth and income” funds. The term “income” refers to the stream of dividends that come in from the fund’s holdings. Stock funds that buy growing companies without regard to whether they currently pay dividends are called “growth” funds. And some companies that buy riskier stocks with more uncertain prospects in the hope of attaining a greater return are sometimes called “aggressive growth” funds. USAA, which markets to military members, has a fund that falls in this category, called, appropriately enough, USAA Aggressive Growth.

There are also funds that concentrate on buying companies for a very low price relative to earnings. For example, a stock that sells for 5 dollars per 1 dollar of earnings per share (a price-to-earnings ratio of 5) is much cheaper than a stock that sells for 20 dollars per 1 dollar of earnings per share (a p/e ratio of 20). These funds are called “value” funds.

Some funds concentrate on very large companies, such as those in the S&P 500 – the 500 largest publicly-traded companies in the U.S., as measured by the total market price of all stock shares outstanding (this value is called market capitalization, or market cap for short.) Other funds concentrate on smaller companies, or small-caps and even very small companies, or micro-caps.

There are also funds that focus on stocks of international companies, as well as funds that focus on single countries or single industries. The narrower the niche, though, the less likely it is that you really need it in your portfolio.

Types of Bond Funds

Just as there are different kinds of stock funds, there are different kinds of bond funds as well.

There are funds that just buy corporate bonds, and bonds that just buy U.S. Treasury bonds. Some funds concentrate on longer term bonds, with repayment periods of 10 to 20 years. These can lock in a stream of interest payments for a long time, but the share prices are subject to wide swings as interest rates rise and fall. The longer the bond’s duration, the wilder the prices will swing up and down as interest rates fluctuate.

Agency bond funds just buy issues like Fannie Mae, Ginnie Mae and Freddie Mac, which are quasi-government agencies that buy mortgages from banks to create a more liquid housing market. These are considered pretty safe, though interest payments, or “yields” are modest. And as we found out in the last few years, agency bonds are not risk free, by a long shot.

Bond funds that concentrate on riskier issues that have a higher possibility of default, but which earn higher interest payments, are called high-yield funds. The bonds they buy are called high-yield bonds – also called junk bonds. These bonds generate more current income than safer bonds.

At the other end of the equation are money market funds. These are special mutual funds that only buy very short-term debt from governments and established corporations. They are designed to have a very stable share price of 1 dollar per share, no matter what – and kick out a very low yield, akin to a bank CD, but you don’t have to lock in your money for a long period of time as you do with CDs.

Unlike bank CDs, though, money market funds don’t come with FDIC insurance. It is possible for investors in money market funds to lose money, though it would be extremely unusual. Generally, the investment companies running these funds have been willing to shore up a money market fund with their own money rather than allow the fund price, or net asset value (NAV) to “break the buck.” However, there is no guarantee whatsoever that they will continue to do so, and they are under no legal obligation.

Mutual Funds Are Risky

Some mutual funds are safer than others. But all mutual funds are subject to some market volatility (except perhaps a well-run money market fund, which is usually considered very safe, though there are no guarantees). Money in mutual funds should be money that you are prepared to take a loss on, at least in the short term. But you cannot make great gains without being prepared to take on risk. If you’re going to create a meaningful retirement nest egg, you are going to have to take on some risk in pursuit of greater returns in the long term. Mutual funds are for the part of your portfolio that you want to have a bumpy 5 to 9 percent return over a period of years, rather than a smooth and even three percent return.

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