How Do Mutual Funds Work?

Lots of people have been emailing me and asking me ‘How Do Mutual Funds Work?’ It can get a little complicated if you want to know all the nitty-gritty details. But the basics are very simple.

Mutual funds are a basket of stocks and/or bonds. When you buy one mutual fund, you gain exposure to tons of different investments, usually dozens or hundreds. It’s an easy way to diversify your investments, which is part of the reason they’re so popular.

Diversification decreases risk. It goes back to the old saying, ‘Don’t put all your eggs in one basket.’ By spreading your money around, you’re not as vulnerable to any one specific risk.

How Do Mutual Funds Work – Advantages

  1. Professional management. Instead of you making investment decisions by yourself, each fund has managers, who make all the decisions. This is good if you don’t have the time or the skills required to manage your own money.
  2. Ease. Investing in mutual funds is easy. You choose a company that you like, like Fidelity or T. Rowe Price, set-up an account, and give them your money. That’s it. Very little research required.

You can hold mutual funds in regular, taxable accounts, or tax-advantaged accounts, like IRAs or 401Ks. They’re usually highly-liquid, so you can buy and sell them just like stocks.

How Do Mutual Funds Work – Disadvantages

  1. Sometimes the managers suck. Fully 85% of mutual funds under-perform the market according to Motley Fool. What’s that mean? It means you could just buy the S&P 500 and be better off.
  2. They’re expensive, man. Regardless of how the management performs, you have to pay fees. Be careful to read the fine print because some mutual funds assess their fees in a tricky way. Usually you don’t notice they’re assessing them.
  3. Over-diversification. Some diversification is good, but you don’t want too much. If you have too much, then market-beating performance becomes almost impossible.
  4. So many choices! How are you supposed to choose? Luckily, there are some new options coming out for people that just don’t want to manage their money. Help is on the horizon.

I usually avoid mutual funds because I feel I can do a good job myself. Plus, I enjoy spending time researching investments (obviously).

When I do use funds, I use Exchange-Traded Funds or ETFs. These work like mutual funds, except they’re not professionally managed. They’re usually much cheaper to own, and perform similarly.

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