Mutual Funds. What you need to know.

Diversification.

Mutual funds, and other pooled investment funds, put your eggs into many baskets. They typically invest your savings in the stocks or bonds of many different companies, industries, and countries, which significantly reduces risk. For example, suppose:

• The mutual fund holds a group of stocks, each of which is expected to increase in value 10% a year, plus or minus 20%. At the end of the year, each stock is expected to be somewhere between 30% higher and 10% lower.
• As a group, these stocks are still expected to rise in value 10% a year – more in good years, less in bad. But as some stocks will increase more than others, offsetting those that increase less, you’re more likely to get a return closer to what you expect. At the end of the year, for example, the value of the group could be expected to be somewhere between 20% higher and unchanged from this year.

Professional management.

Mutual funds are managed by professional investment managers. While they do not always meet or beat expectations, they are less likely to make costly investment mistakes.

Fees Seem Small, But Their Effect Is Large

Mutual funds typically charge a percent of your savings invested. Some also have fees for buying and selling shares.

• “Index” funds generally have the lowest fees because they do not have managers that pick stocks, but merely track a particular index, such as the Standard and Poor’s Index of the stocks of the 500 largest U.S. corporations. A typical fee is 0.2% of your savings in the fund per year.
• More expensive are funds that have investment managers who invest your savings in particular stocks and bonds. After paying fees, these funds sometimes, but hardly always, out-perform index funds. A typical fee is 0.7% of your savings in the fund per year.

Most expensive are funds in some smaller 401(k) plans, which have higher administrative and marketing costs per participant. A typical fee is over 1.0%.

Fees might seem small. But if you contribute to a 401(k) from age 25 to retirement at age 65, then decide you can safely withdraw 4% including fees out of your savings each year:

You Can Dial “Risk & Return” Up or Down

Experts say your most important investment decision is to strike the proper balance between growth and safety. Using mutual funds, that means picking an Aggressive, Conservative, or “In-between” Fund.

• Growth funds put most of your savings in investments, such as stocks, that are expected to grow quickly, but are risky.
• Conservative funds put most of your savings in investments that have less risk but lower expected returns, such as bonds.
• Moderate funds put your savings in investments that have expected returns and risks somewhere in-between.

Experts recommend a shift from growth to safety as you age. Target Date Funds (TDFs) do that for you:

SECTOR FUNDS

Some mutual funds invest your savings in a particular sector, such as an:

• Industry, such as technology or energy stocks
• Region or Nation, such as Europe or China
• Asset, such as stocks, bonds, or real estate
• Group, such as small companies or “emerging markets” (overseas developing economies).

Sector funds are less diversified and thus more risky, but allow you to use mutual funds to invest in a particular “sector.”

Here is a video from the Khan Academy that explains more about mutual funds: