Money Matters

Investors Column – What are Mutual Funds?

A mutual fund is a way to invest in a greater variety of stocks than would normally be possible for most people.

You and thousands of others like you buy shares in mutual fund, just like buying stock. The mutual fund’s managers use that money to buy perhaps dozens of stocks. Depending on how the value of those stocks go up or down, the mutual fund’s value increases or decreases.

Just like stocks, the value of your shares of a mutual fund can go up or down. There is no guarantee of increasing the value of your money. Select the mutual funds that are right for you with that in mind.

Typically, a mutual fund focuses on specific types of stocks: manufacturing, high-tech, transportation, etc. Some mutual funds aim for a “balanced” portfolio, owning a mixture of bonds and stocks. Others focus on “aggressive” stocks, in the hope that their prices will increase more quickly than the average. Some funds focus on producing steady income, mainly via stocks that pay higher dividends, which is usually sought by those who are retired.

Some mutual funds focus on “small-cap” stocks, generally buying the stocks of smaller companies, valued at less than five or ten billion dollars. Small-cap funds tend to do better than the average when the economy is doing well, so even if you do not buy shares in a small-cap mutual fund, tracking its progress over time compared to a “balanced” fund can tell you how the economy is doing.

Mutual funds that focus on Asian stocks or third-world stocks seem to do well when the U.S. economy is slow but the rest of the world’s economy is improving. The choice of when to choose mutual funds specializing on third-world stocks must be done carefully. In many ways, “all financial roads lead to the U.S.” The U.S. dominates the world’s economy, and what happens in the U.S. will affect the world economy. But that impact can be delayed, offering an occasional period where non-U.S. stocks out-perform U.S. stocks.

An alternative to mutual funds that focus on third-world stocks is to look at U.S. companies that have a large presence in third-world countries. Those can offer the growth rates of third-world investing, combined with the foundation of U.S.-style accounting, operations, and general integrity.

Mutual funds typically charge fees as part of the cost of joining a mutual fund. Mutual funds can be “front-end” or “back-end”, meaning you pay the fee when you first buy the mutual fund’s shares, or when you sell the shares. If you own enough shares, that fee may be reduced or eliminated. Also, investment companies that own a number of mutual funds will usually allow you to move money from one to another without paying any fees.

Another cost to owning shares in a mutual fund: any capital gains made by a mutual fund will be distributed to the shareholders. You will have to pay taxes on your shares, the same as for stock dividends, if they are in an after-tax account.

Part of the attraction of mutual funds is that each fund’s manager is a professional whose career is devoted to building the skills that are needed to make his investments successful. But as has been mentioned in previous Investors’ Columns, there is no fixed formula for success. Each investor builds up a set of skills and habits that works for him.

However, when a particular sector of the market is outperforming everything else, the professional is just as prone to abandoning his judgement and following the crowd into some impulse buying as anyone else. A good investor maintains his personal discipline, and focuses on long-term success. Investor Warren Buffet is probably the best role model in that regard.
\Mutual funds are usually used for the investment of employees’ deposits into 401k accounts. Companies will negotiate with a particular investment company to offer several mutual funds into which employees can choose to put their 401k money. Typically, the choices will be fairly conservative, ranging from a money-market fund (essentially, a savings account) and a bond fund, to a range of fairly-conservative mutual funds that offer minimal risk and a limited if decent level of increased value potential.

Most funds available through a 401k are deliberately oriented for the risk-averse. As mentioned in last month’s Investors’ Column, most people are risk-averse, and fear losses. That drives a company’s choice of mutual funds to be offered for their 401k.

If you are willing to accept greater risk, one option is to periodically (every two or three years) move money out of your 401k, into your IRA, where you can then buy more aggressive mutual funds or actual stocks of your choice.

Note of Caution: Your rmust move money taken out of a 401k into an IRA. Money in a 401k or IRA is “pre-tax”. If you withdraw money from your 401k or IRA and then spend it or treat it like “after-tax” money, the IRS will want the tax which is due. If your age is less than 59 1/2, you will also have to pay a ten-percent penalty to the IRS. Your investment adviser can explain this in more detail.

But if you are interested in becoming a better investor, moving your money from a 401k to your IRA is an excellent way to build your investing skills. Just remember: to do so will also increase your risk. If you are to retire comfortably and choose this path, investment success is ultimately a requirement for you.

Most investment advisers will strongly urge you to stay within the standard list of mutual funds offered by that company, and may even require you to sign a statement that you will not hold their company responsible for any losses, should you begin making other, non-standard investment decisions.
Most people are not very good investors, and plans drawn up by investment advisers are intended for their benefit. When you begin making your own investment decisions, you are stepping out of that norm; your investments are based on your independent decisions. Take small steps at first; there will be times when you will lose money. Hone your skills carefully. The goal is to make more money than you lose. To become an investor is exciting and challenging, but choosing that path must be done with your eyes wide open to the risks, as well as having the determination to learn what is needed to be successful.

Next Month:
Company Takeover!■

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