your 401(k) #9: intro to mutual funds

En Español

What is a mutual fund? Why do they exist? What value do they offer?

Before moving on to the next two asset classes - equities and fixed income - you need to understand what a mutual fund is and how it works. Why? Because:

Mutual funds are the “gateway” to equities and fixed income in most retirement accounts.

Buying individual stocks or bonds isn't often an option in your retirement plan. Instead, you're able to “own” a variety of securities by pooling your money together with other investors. You do this by purchasing units (shares) in a mutual fund.

Mutual funds are investment companies that pool many peoples' money and invest it on their behalf. Here's how the flow of money works: 

You buy units in the mutual fund - you give the mutual fund money and get shares of ownership in return. 


The fund then combines your money with other investors’ money and uses it to buy various stocks and/or bonds. 


The combination of securities that the fund owns is called its portfolio, and it's that portfolio that you own a slice of. 

*** Misconception: You don't actually own shares of each of the individual companies, only units of the mutual fund. But those units give you exposure to all of the securities in the mutual fund's portfolio. ***


In other words, what happens to the portfolio happens to your money:

  • If the net value of the portfolio's investments go up, then the value of your units will go up as well.
  • If the majority of the holdings’ value decreases, then the value of your units will go down too.


net asset value (NAV)

With mutual fund units, the “price of a slice” (the price of each unit) is called the Net Asset Value, or NAV for short. A fund’s NAV is calculated by dividing its net portfolio value by its number of units outstanding.

NAV  =  Net Portfolio Value  /  # of units

It’s similar to the relationship between a company’s market cap and its share price.

  • If a mutual fund's net portfolio is worth $100 million and the fund has 1 million units outstanding, then the price of each unit is $100. The NAV = $100.
    • If you have $1,000 to invest, you could buy 10 units at $100 per unit. 
  • If the fund’s investments generate a +10% return, the fund's portfolio value would increase to $110 million. With the same 1 million units outstanding, the NAV would grow to $110.
    • That means your 10 units would be worth $1,100 (ie. you earned $100 on your investment).
  • If the fund's investments decline 10%, the portfolio would only be worth $90 million. With 1 million units outstanding, the NAV would go down to $90.  
    • our 10 units would then only be worth $900 (ie. you lost $100 on your investment).


mutual fund categories

Mutual funds fall into three basic categories:

  1. Money market funds (MMkt or MMF for short)
    • Invest in short-term, cash-like securities. Money market funds are considered low risk and generate a small return.
  2. Equity funds
    • Invest in public company stocks. They are considered higher risk but have higher return potential.
  3. Fixed income funds
    • Invest in mostly government and corporate bonds. They are considered lower risk and have a low-mid return potential.

The types of stocks or bonds that a fund invests in depends on its strategy and investment goals. You’ll learn about the different strategies in the next few videos.


pros & cons

There are positives and negatives to investing in mutual funds.


  • Convenience
    • Mutual funds do what most people don’t have time, knowledge, or desire to do themselves.
  • Variety aka Diversification
    • Instead of selecting a handful of individual stocks or bonds yourself, owning shares of a mutual fund gives you exposure to tens or hundreds of stocks. This gives you diversification - spreading your risk around by not putting all of your eggs in one basket.  
  • Lower upfront investment cost
    • Buying 1 share each of Apple, Google, Facebook, Microsoft, Amazon, GE, and Verizon would cost you almost $2000 today (8/3/16).
    • That same $2000 could buy you 10 units of a “500 fund” that cost $200 each. A “500 fund” invests in all of the companies in the S&P 500, so owning 10 units would give you exposure to all 500 of those companies (including Apple, Google, Facebook, etc).



  • Price
    • Mutual funds charge a fee - typically a percentage of your account balance - to manage your money.
    • This fee can range from as low as 0.07% (7 cents for every $100 invested) to over 2.0% ($2 for every $100 invested).
    • Those numbers might not seem that high, but over time, fees can really add up!
      • That's right! Your retirement account is NOT free! You're paying to have that money managed for you.
  • Lack of transparency
    • Most funds only publish their biggest investments. That means that you, as the investor, never know all of the stocks or bonds that a particular fund owns.
  • Over-diversification
    • Some funds own stock in hundreds of different companies. This can prevent any one stock from having a big enough impact on the fund's overall return.
      • This is good when one stock goes down significantly - the other stocks sort of mask that one's decline.
      • But it's not good when one stock goes up significantly - the other stocks weigh the rest of the portfolio down. 
  • Selection
    • Retirement plans are like snowflakes - each one is unique.
    • The mutual funds that YOU are able to invest in depend on which ones are offered in YOUR plan. Some plans offer great, low-fee investment options. Others are a basket of expensive funds that underperform the broader market. As Forrest Gump would say:
Retirement account plans are like a box of chocolates. You never know what you’re gonna get.

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