What Is a Mutual Fund?

A mutual fund is an investment vehicle that pools the money of many investors to buy a large number of investments. By pooling small amounts of money invested by thousands of individuals, a mutual fund can invest in dozens of different stocks, bonds, and other securities. When you buy shares in the fund, you become a part owner of all those investments, and as those investments grow, so will your money. When you buy a share in a mutual fund, you are participating in the performance of all the investments selected by the manager of the fund. Most individuals don’t have the resources to invest in a wide range of stocks, bonds, or other investment vehicles, nor do they have the money to hire a professional money manager to choose investments for them In order to understand how mutual funds work, you need to understand the difference between mutual funds and the stocks and bonds that are owned by a mutual fund. A share of stock represents part ownership of a company. When you own a share of IBM, Walt Disney, General Motors, or Amazon.com, you own a (tiny) portion of that company. If the company’s sales and profits increase, you benefit: You’re likely to receive dividends, which are payments of a portion of a company’s profits to shareholders. Plus, the value of your stock probably increases as the company prospers. By contrast, a bond is like an IOU. A bond represents a loan of money to the managers of a business or a government agency; they promise to pay you back, with interest, over a specified period of time. You can buy and sell bonds on the open market (usually with the help of a financial professional called a broker). When you buy a bond, you are purchasing the promise of repayment with interest. Like shares of stock, bonds may rise and fall in value.
Bonds usually change in value based on changes in interest rates: In general, when interest rates rise, bonds fall in value, and vice versa A mutual fund is a collection (or portfolio) of individual stocks, bonds, and (rarely) other kinds of securities that are generally of interest only to financial specialists. The mutual fund manager selects the stocks and bonds based on the investment objectives and style of the particular fund and on the manager’s judgment as to which investments are likely to be most profitable. (In later chapters, I explain how you can determine the objectives and style of a particular fund and whether that fund is a good choice for you.) In general, if the manager selects wisely, investors in the mutual fund benefit; if the manager’s choices are poor, the investors suffer. Thus, the main difference between a mutual fund and individual stocks and bonds is that the person who invests in a mutual fund owns shares in an entire portfolio of stock or bond investments, managed by a knowledgeable financial professional. It’s like handing your investment money to an expert and saying, “Here — you pick some good investments for me, and send me the profits.”
The sale and trading of mutual funds, stocks, and bonds is regulated by the Securities and Exchange Commission (SEC), a government agency that protects investors from fraud and theft. However, the value of your investment in a mutual fund (or an individual stock or bond) is not guaranteed by the SEC or by any other government institution. You can lose money on a mutual fund investment — in an extreme case, even all your money. However, the safety track record of most mutual funds is quite good. In fact, since the passage of the Investment Company Act of 1940, which regulates mutual funds, no fund has collapsed or gone bankrupt.

Learning about Mutual Funds

Mutual funds are a very popular means of investing money. A mutual fund pools money received from individual investors like you — often in modest amounts — to create a large investment fund. A professional fund manager with detailed knowledge of investing then puts this money to work for you. As the money grows over time, so does the value of your investment.
The money in mutual funds is usually invested either in stocks or in bonds. Stocks represent shares in the ownership of companies. When you own stocks, you share in the profits the companies enjoy, and when the value of the companies grows, so does the value of your stocks. Bonds, on the other hand, represent money that has been borrowed by a company or a government agency. When the loan is repaid, the owner of the bond gets the money back with interest. When you invest in a mutual fund, your money goes with the money of many other people to buy stocks or bonds. As the mutual fund that owns the stocks or bonds profits from these investments, so do you.

The price you pay for tapping your retirement accounts early

Don’t do it. I repeat, please do not take money out of your retirement accounts on a whim, say, when you’re changing jobs or feel the need for an extravagant vacation. If you make the withdrawal anyway and you’re not age 591⁄2yet, you can look forward to the double whammy of both taxes and a penalty. First, you have to pay tax on any capital gains in the account. Then, you have to pay the IRS a 10% penalty. The same holds true for early withdrawals from regular IRAs. The IRS has agreed to waive the early withdrawal penalty on qualified withdrawals made from Roth IRAs before age 591⁄2—these include first-time home purchases and college education for the kids — but you still have to pay the taxes. Borrowing from retirement plans can be as bad or worse because you pay interest to borrow your own money. And you lose the interest you would have earned on these accounts.
Pecking away at retirement savings is no way to build your nest egg. If you’re changing jobs and don’t want to leave your money in the former employer’s 401(k) plan, roll the money directly over to an IRA at the fund company or broker-dealer where you have your other investments. Fill out a form that your former employer provides directing them ( or their plan provider) to roll your plan money into an IRA at your next firm. Make sure that you set up the account with the new firm first.

Choosing Tax-deferred investing

Don’t forget to take advantage of any form of tax-deferred investing available to you. Max out on the retirement plans offered to you at work (such as your 401(k) plan). Investing in this way really does boil down to a choice of paying yourself or paying the IRS.
With retirement plans such as a 401(k), you enjoy the added bonus of being able to deduct your contributions, up to a maximum of 15% of what you earn, from your income each year for tax purposes. Now that’s hard to beat. The maximum amount that you can deduct depends on the plan. Some plans allow 8%, some 10%. But no plan is allowed, by law, more than 15%.
Contributions made to a 401(k) plan are deductible from gross income for income tax purposes. If you do your taxes yourself, you deduct your overall annual contribution from your gross income. If an accountant or attorney does your taxes, she or he does the deduction for you. Just as hard to beat is the Roth IRA. If you have adjusted gross income under $95,000 as an individual, you can tuck away $2,000 in a Roth IRA each year and begin to take distributions tax-free when you hit the age of 591⁄2. If you’re married and you and your spouse have a combined adjusted gross income of $150,000 or less, you can tuck away $4,000 a year. Unlike regular IRAs, Roth IRAs allow investments even if you’re enrolled in an employer-sponsored retirement plan. The same goes for self-employed folks. With the Roth, you get tax-free capital gains every year, and you get to take withdrawals tax-free when you hit retirement age at 591⁄2, provided you’ve had the account for at least five years. Deductions for an IRA differ in that you take a dollar amount deduction, not a percentage of your gross income. The maximum deduction for an IRA is $2,000 per individual, if you qualify for the plan.

Choosing Bonds

Price appreciation (if any) on a bond — whether it is a corporate, government, or municipal bond — is taxable when the bond matures. Interest on municipal bonds is exempt from federal tax, but may be subject to state and local tax (depending on if you live in the state or locality doing the issuing). Interest on U.S. government bonds is exempt from tax at the state level, but taxable at the federal level. If you buy a bond from Fannie Mae or Ginnie Mae ( the quasi-government agencies that guarantee mortgages), then gains are taxable at the local, state, and federal level.

Choosing Stocks

With stocks, you don’t pay taxes on your gains until you sell your shares — a feature which fans of stock investing say is a clear advantage in the long run. The downside, however, is that when you do cash in shares down the road, your tax bracket or the tax rate may have increased.
If you do have a stock loss ( which means a stock is worth less than what you bought it for), but the stock is one you want to own, consider selling the stock and rebuying shares at a lower price. The IRS allows you to consider this a wash sale, so you won’t have to pay capital gains tax. Note that you must wait 31 or more days before you can buy back the stock or else the IRS doesn’t allow the deduction.

Choosing mutual funds

With mutual funds, unfortunately, you have to pay tax each year on the capital gains and dividends that the fund distributes to each of its shareholders. You also have to pay taxes on your own gains when you sell shares — another reason for a long-term buy-and-hold strategy. The exceptions are funds that invest in U.S. securities. You still have to pay federal income tax on any gains, but you’re free of state and local tax in most situations.
Although some people believe that municipal bond funds are free of federal income tax, that’s only true of municipal bond investments themselves. You pay taxes on capital gains on any profits that a municipal fund makes from selling bonds.

Choosing savings accounts

The gains on simple savings accounts, CDs, and money market accounts are taxed as income at the local, state, and federal level. Banks and financial institutions report these gains to the IRS and state tax offices, just as all investment gains are reported.

Developing a Dollar Cost Averaging Plan

No one can afford to have his or her investing plan be forgotten or relegated to the back burner. You need to set up a plan for making set, regular investments. This way, you can ensure that your money is working for you even if your best intentions are diverted.
Dollar cost averaging is a way to ensure that you make fixed investments every month or quarter, regardless of other distractions in your life. Dollar-cost averaging is a simple concept:
You invest a specified dollar amount each month without concern about the price per share or cost of the bond. The market is fluid — the price of your investment moves up and down — so you end up buying shares when they’re inexpensive, some when they’re expensive, and some when they’re somewhere in between. Because of the commission cost to buy small amounts of stocks or bonds, dollar cost averaging is better suited for buying mutual funds.
If you have a 401(k) plan at work, you already have experience with dollar cost averaging. You fill out the forms for the plan and direct your payroll department to take a certain dollar amount or percentage of your pay every payday and use it to buy the mutual funds, stocks, bonds, and/or money market account you’ve selected. Investing this way is important for your retirement accounts and your financial plans:
It’s the only way most of us can grow our money in a consistent manner.
In addition to helping you overcome procrastination about saving for investments, dollar cost averaging can help you sidestep some of the anxiety many first-time investors feel about starting to invest in a market that can seem too overheated or risky. With set purchases each month or quarter, you buy shares of your chosen investments regardless of how the market is doing.
Dollar-cost averaging isn’t statistically the most lucrative way to invest. Because markets rise more often than they decline, you’re better off saving up your money and buying stocks, bonds, or mutual funds when they hit rock bottom. But dollar cost averaging is the most disciplined and reliable way to invest. Consider this: If you set up a dollar-cost averaging plan now, then in 10, 20, or 30 years, you’ll have invested every month in between and accumulated a pretty penny in the interim.
Most mutual funds let you start out on a dollar cost averaging plan (or automatic investing plan, as they’re also called) for as little as $50 or $100 a month. The only catch is that you have to sign up to allow the fund to take the money from your checking account each month. To find out if the funds you’re interested in offer the service, look for the information in their prospectuses or call their toll-free shareholder services phone number.

Starting and Staying with a Diversified Investment Approach

The goal of diversification is to minimize risk. Instead of putting your eggs in one basket by investing every dime you have in one stock, one bond, or one mutual fund, you should diversify.

Diversification is a strategy for investing in a wide array of investments that ideally move slightly out of step with each other. For example, an investment in an international mutual fund might be doing poorly while an investment in a U.S. stock mutual fund is doing well. By investing in different sectors of the investment markets, you create a balanced portfolio. Parts of that portfolio should zig when other sections zag. Table 9-1 shows the power of diversification by examining how three different diversified portfolios of money markets, bonds, and stocks can fare over time. The table also give you a concrete idea of the investments that should go in a portfolio based on your own tolerance for risk. They’re also a good way for you to measure whether your own portfolio is diverse enough for your own tolerance for risk or loss. It’s important to determine the percentage of stocks, bonds, and cash you want in your portfolio. In the stock and bond categories (or mutual funds that invest in these assets), it’s also important not to load up on any one sector of the economy.

So steer clear of the temptation to invest in three technology mutual funds, four Internet stocks, or six junk bonds even if they’re paying more than other investments.
The saying “no pain, no gain” also applies to the investment experience. You can avoid the prospect of experiencing any pain at all by investing only in money markets and CDs that are federally insured. The price to be paid for that strategy:

You may never lose money in the traditional sense, but you never gain much either, which means that you can still fall behind. You also run the risk of falling behind because of inflation, which eat ups approximately 3% of your purchasing power each year. If you only earn 4% or 5% a year on your savings or investments, you’ll have a hard time preserving the capital you have, let alone growing it.