"One Question....How Do Mutual Funds Work?"

I have been asked a number of times to provide a simple answer to the question, "How do mutual funds function?”

Let’s imagine a basket.  Within this basket there are certificates that say “Wal-Mart”, and “Exxon”, and “John Deere”.  These certificates with the companies’ names on them represent small pieces of ownership in those companies.   Similar to a deed to a house or a title to a car, the certificate confirms ownership.

These certificates are called stocks, and they have a value that changes multiple times throughout the day.  The certificate’s value changes based upon how well the company (whose name is on that certificate) performs or is expected to perform.

Now, as the companies’ certificates go, so goes the basket.  The basket also has a value or price and this price changes once per day based upon the price of the certificates that are in your basket.

Now imagine a person who oversees this process.  Let’s call him a basket manager.  His job is to look very closely at those individual companies like Wal-Mart”, and “Exxon”, and “John Deere”.  He decides if these are companies worthy to be placed in his basket.  His primary goal is to manage a good basket, chocked full of good companies.

These basket managers are paid (rather handsomely I might add) to get good returns on their basket and to make the basket grow in value for those that invest in the mutual fund basket.  

So, an investor like you provides cash for the mutual fund basket.  The manager on behalf of the basket buys more certificates of companies that he/she thinks will eventually make their basket more valuable.

If the manager’s basket out-grows their peers’ basket, he/she may earn a platform on which to advertise their mutual fund basket.  They hopefully find themselves on the “ten best mutual funds” list, or the coveted “10 best mutual funds your 401k can’t live without” list and so forth.  

On the other hand, if the fund manager doesn’t do as well as expected, watch out.  They may very well find themselves on a list that they never hoped to be on.

So, what do you get when you buy a mutual fund?  Well, you get ownership of the basket, and that could be either good or bad depending on the companies that are in the basket.  Not all mutual fund baskets are created equal and it takes some skill when picking mutual funds.  

Even if an investor errs and picks a mutual fund that doesn’t make the “top ten list”, there are still excellent reasons to own mutual funds.

Throwing the baby out with the bathwater is bad business and anyway, and mutual funds are often the best option we have.  Here’s why.

• Diversification.  For purposes here, diversification is the idea of reducing the impact of owning a poor company in the basket.  The more individual stocks or bonds the basket contains, the less impact there is of owning a mutual basket.
• Simplicity.  No need to buy individual stock certificates.  Just buy the mutual fund basket and you get many stocks based upon your mutual fund basket selection.
• Liquidity.  Liquidity is a term used to describe how quickly or easily an investment can be turned into cash.  For example, a 10,000 acre ranch has less liquidity than a 401k mutual fund.  Generally, these mutual fund baskets can be sold for cash in just a few days.
• Divisible.  Mutual funds excel here as well.  Generally, a $1,000 investment in mutual funds can be divided amount many different fund choices.
  

I hope this page clarifies the mutual fund.  If it does, congratulations!  Now you know what to say if someone asks you the question, “How do mutual funds work?”

 

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