What is a Mutual Fund?
We have heard the term many times and have perhaps been enticed to try it, but just what exactly is a mutual fund? Imagine that you want to own a small piece of a company, so you purchase a share of stock in that company. As it becomes profitable, the value of your share of stock increases in value. What happens if the company has a bad year? Your stock in that company also has a bad year, and the value of your piece of the company decreases. Now imagine that you could somehow take that one share and invest it in 100 companies instead of just one. What happens if 30 of those companies do poorly? The value of your stock may decrease, but if the other 70 are doing fairly well, their success could offset the bad year the others are having.
In a similar manner, these funds allow you to invest in many different companies. You own a share of the mutual fund itself which includes the returns of all of the companies in which it invests, but also any loses it has, and any fees that the fund may charge for providing investment expertise. The good thing about it is, that a mutual fund provides you with professional money management. The money managers do the research and daily tracking of companies that we don't have time for. Additionally, their pay is usually tied to the performance of the fund, so that is a great incentive for them to get it right.
What Are The Potential Rewards of Investing in Mutual Funds?
Let's go back to our example of monthly savings. You decide to save $100 each month and you put it into a mutual fund, averaging a 7% annual return over the next 15 years. Your $100 monthly savings after 15 years would turn into $31,881! Now compare that with what you are earning in your bank account. As of this writing, today's bank rates are at about 1% at best. Clearly, if your financial goal is long term, a mutual fund may be a much better way to go. There still is always a place for a savings account though, especially when saving for short term goals like vacations, home improvement projects, emergency funds, a new home or vehicle, and so forth.
As we hinted at out the outset, many people have shied away from mutual funds because of the loss of so much money in 2008. However, that need not frighten you away from using such effective savings vehicles. It takes time and effort to find a mutual fund that has fared well during the good and bad times, but the rewards are well worth it, if you have long term financial goals. In a future article we will discuss the folly of putting off developing a savings plan for years, versus the benefits of starting a savings plan as early as possible.