How Mutual Funds Work

saving moneyDo you own a mutual fund? It’s likely that somewhere in your retirement accounts you are invested in at least one. In fact, 92 million people or 44% of all U.S. households have investments in one of the ore than 7,000 mutual funds available. If you are invested in mutual funds, do you know what they are and how they work? Here’s the basics of mutual funds that every investor should know.

Let’s illustrate how they work with a story. You and 10 of your work friends have a spare $1,000 they would like to invest. You all know that in investing terms, $1,000 isn’t much money and not likely to attract the attention of an investing professional that will help you so you come up with an idea. What if you combined your $1,000 and made a pool of $10,000?

That’s still not a lot of money so you ask other work friends and other people you know. Before long, you now have 100 people willing to invest $1,000 making your total pool, $100,000. Your idea is that you would combine all of the money and make up rules of how that money would be invested. Maybe you only want the safest investment or investments that mirrored the performance of the Dow Jones Industrial Average or S&P 500.

You don’t have the expertise to do it yourself so you hire a manager for your pool of money and pay them 1% each year to follow your investment guidelines. Each person has an equal 1/100th stake in the fund but others could come in to your fund and invest more or less than $1,000 and receive a share of the profits or losses equal to the size of their investment after all of the fees are paid.

What you and your friends just formed is a basic version of mutual fund.

If you own a mutual fund, you’re not involved in forming the fund but you do share in the profits of the fund equal to the amount of money you have invested. Mutual funds can be an effective way of funding your retirement but some funds are better than others.

When deciding on the funds you want to have in your portfolio first consider the fees. In 2011, the overall stock market didn’t appreciate at all leaving only dividend (fancy word similar to interest) payments. These payments may only equal 2% to 5% in a year so fees matter. If you’re paying 2% each year in fees but the fund only made 3%, you’re now down to 1% and 1% doesn’t even beat the rate of inflation

When evaluating a fund, first look at how much in fees you’ll pay, then look at the performance over the past few years. Remember that bond funds are more conservative than stock funds and in most cases you should have a mixture of both.

If you don’t have experience picking investment options, consider asking for a help from a trusted, fee only adviser in your area. You only get one chance to invest for retirement correctly.