Risk involving changes in the market

Even with expert management, however, the risk involved in mutual fund investing does not disappear. Sometimes, the stock or bond market as a whole may be in decline, and even smart investors are unable to make a profit. Such hard times are referred to as bear markets.
The opposite of a bear market is a time when the markets are steadily rising — bull market. Pessimistic investors are sometimes referred to as bears, while optimists are bulls. Now you understand the livestock references that you often hear scattered throughout financial news reports!
If you’re a long-term investor, bear markets may not be a problem. You can probably wait until the market rebounds before selling your shares. A short-term investor, however, may get stuck with losses. Although you can’t avoid risk altogether, you can choose money market mutual funds or other investments that don’t tend to fluctuate dramatically.

Risks involving fund management

These days, mutual funds are among your safer investment options. Diversification, professional management, and the fraud-prevention exercised by the Security Exchange Commission and other regulatory bodies all help ensure that mutual funds stay relatively safe. Nonetheless, investing in mutual funds carries various kinds of risk that can impact your financial planning.

One risk that’s inherent in the nature of mutual funds is the fact that you, the investor, have no control over what’s being purchased for the portfolio. You are putting your money —and your investment fate — in the hands of the fund manager, which is why you need to study the track record of the fund company and the individual manager before you invest. Making sure that you’re giving your money to a reliable partner is important to your pocketbook and your peace of mind.

Another unpredictable challenge may arise when a fund’s “star” manager retires or changes jobs, leaving the fund without his expertise or brilliance. For example, Peter Lynch was one of the most successful and famous mutual fund managers in the world for many years. Under his guidance, the Fidelity Magellan Fund grew into the largest mutual fund anywhere, with over $72 billion in assets. Millions of investors poured money into Magellan, attracted largely by Lynch’s reputation and prestige. Since Lynch’s retirement in 1990, however, Magellan has performed with far less success, despite the strong performance of the stock market overall. If you’re a fund investor, follow the financial news. Be aware when changes in the management of your funds occur. You may want to consider switching funds when the manager responsible for your fund’s track record departs the scene.

Shareholder services of Mutual Funds

Many mutual fund companies offer a range of useful, sometimes valuable services to their customers. These may include

• Check-writing privileges
• Ability to invest, withdraw, or move money via mail, telephone, or the Internet
• Automatic investment via payroll deduction
• Record-keeping for filing your income tax return
• Access to research reports about companies, funds, and economic trends

A fund’s prospectus tells you more about such services.

Liquidity of Mutual Funds

Liquidity refers to the ease with which you can buy or sell an investment. Buying or selling a particular stock or bond, especially one held by relatively few people, may be difficult. If you need cash in an emergency, this obstacle to turning your investment into legal tender can cause inconvenience and may cost you money. By contrast, mutual fund shares can be cashed in quickly at any time by redeeming them with the managing company, usually at little or no cost.

Professional management of Mutual Funds

Mutual funds hire smart investment experts to manage your money, and they have access to extensive research into companies, economic conditions, and market trends. Most people would have a hard time keeping track of a large number of investments in many different businesses; staying on top of that financial activity is part of the daily routine for the research staff of a mutual fund.

Low cost entry of mutual funds

You can get started in mutual fund investing with relatively little money — a benefit when finances are tight, but you’re mentally ready to roll with an investment experience. When you buy shares of an individual stock, any purchase less than 100 shares is usually considered an odd lot, on which you must pay a high sales commission. But a bundle of 100 shares of stock isn’t easy for most investors to afford. If a stock is trading at (for example) $75 per share, 100 shares will cost $7,500 — a significant amount of money for most people.

By contrast, you can start investing in most mutual funds for just $1,000 to $2,000, and add to your investment later with even smaller amounts by sending a check to the fund company or arranging for automatic deductions from your checking account.) If you have only a small amount of money to invest but are eager to get started in mutual funds. This list, which is based on information provided by The Mutual Fund Education Alliance, gives you a sampling of fund companies and categories to consider when you’re looking to invest $500 or less. You can request information on specific funds by contacting any broker, the fund companies themselves, or The Mutual Fund Education Alliance (www.mfea.com).

Diversification of Mutual Funds

Diversification involves spreading your money around among several different kinds of investments in order to reduce the risk of concentrating in a single security. When your investments are diversified, you don’t take a major hit if any one investment performs poorly. Thus, the savvy investor avoids concentrating all her investments in the stock of a single company, or even a single industry. You may be lucky enough to work for a company that helps you invest through a 401(k) retirement plan or by awarding you stock options — the opportunity to buy the company’s stock at a special, often discounted, price. Either way, you enjoy a great reward for being an employee. But be careful — employees sometimes end up investing almost their entire savings in the stock of the company they work for. All is well as long as the company is flourishing. But if the industry suffers a downturn, or if your own company happens to go bankrupt, you may find that your investment is suddenly worth little or nothing.

Mutual funds also allow you to diversify your investments at a relatively low cost. Because of transaction costs (the fees charged when you buy or sell stock), you can waste time and Volatile investment Volatile investment money buying one or two shares of stock in a dozen different companies, which may be all that an investor with a couple of thousand dollars can afford. But the same investor can easily afford to invest in one or more mutual funds. Buying mutual fund shares makes you a part owner of many different types of stocks (or bonds), giving you the benefits of diversification at a fraction of the cost. By definition, any mutual fund offers some degree of diversification, because every fund invests in many different stocks or bonds. But some funds are more diversified than others. For example, sector funds, which concentrate on investing in a single industry, are less diversified than most other stock funds. When economic trends favor that industry, the corresponding sector fund profits.

For example, during the late 1990s, sector funds that concentrate on the stock of Internet companies and other hi-tech businesses have done very well. If and when high-tech industry flounders, however, the technology funds will, too. Thus, keeping all your money is one such fund would be a risky strategy.

Closed-End Funds versus Open-End Funds

The most popular kind of mutual fund is known as an openend fund. (In fact, unless it’s otherwise stated, you can assume that any mutual fund you hear or read about is an open-end fund.) An open-end fund continuously issues new shares and redeems old shares on demand.
When such a fund is popular, money flows in to the fund manager from investors who are eager to own shares. The manager then invests this new money in additional stocks and/or bonds. New shares in the fund are constantly being created.
By contrast, closed-end funds issue a fixed number of shares. After investors buy these shares, no more money can enter the fund. If you want to sell shares that you own, you don’t sell them to the fund management firm, as with an open-end fund. Instead, the shares trade on an exchange, much like the trading of shares in the stock of individual companies. Thus, the price of a share in a closed-end fund is set by supply and demand: If investors are eager to buy the shares, the price rises; if not, the price falls.
Like an open-end fund, a closed-end fund has a net asset value, computed by dividing the total value of the fund’s portfolio holdings by the number of shares. However, the shares of an open-end fund may sell at a premium to the NAV (that is, for more than the NAV) or at a discount to the NAV (that is, for less than the NAV).
For instance, if a particular closed-end fund has an NAV of, say, $15 per share, the actual price at which the shares trade may be higher (say, $18 per share) or lower (say, $11 per share).
Of course, you’re better off buying shares of a closed-end fund at a discount rather than at a premium. In fact, experts generally advise investors to buy closed-end fund shares only when they’re available at an attractive discount. A mutual fund company may decide to offer a closed-end fund rather than an open-end fund for several reasons. The main consideration: a desire to avoid having too much money to invest.
With a closed-end fund, the fund manager knows how much money he must handle; he doesn’t continually get new money to invest, as may be the case with an open-end fund. In some investment markets, closed-end may be a better way of doing business.
For example, an emerging market (that is, a new or relatively undeveloped business region, such as South America or Eastern Europe) may have only a limited number of good companies in which to invest. The manager of a fund specializing in such a market may worry about taking in more money than he can invest wisely. A closed-end fund solves this problem. For the average investor, open-end funds are a better choice than closed-end funds. Newspapers and financial magazines cover open-end funds more extensively, which makes it easier to track them. They are more liquid than close-end funds —that is, easier and more convenient to buy and sell. And their prices are less volatile; upward and downward movement is slower and more predictable.
Some sophisticated investors are especially interested in closed-end funds, but they are probably not the best starting point for the individual who is new to mutual funds.

What is capital gains?

The mutual fund manager buys and sells stocks and bonds continually, in response both to changing market conditions and to the flow of money into or out of the fund. When the manager sells a stock or bond at a higher price than he paid for it, the difference is a kind of profit known as a capital gain. As with dividends, the capital gains received by a mutual fund are distributed to owners of the fund, usually in the form of additional fund shares.
When tax time arrives, the Internal Revenue Service calls for varying treatments for the different kinds of profit you make when you own a mutual fund.

What is Dividends?

Dividends are a portion of the profits earned by a company, which the company may distribute to their stockholders. Not all companies pay dividends. Young, quick-growing companies may choose to reinvest all their profits in further company growth, spending the money to hire new employees, buy new machinery, or develop new business ideas. However, older, more-established companies often pay regular dividends — usually four times a year — to their shareholders, calculated on the basis of so many cents per share owned. For example, if a company decides to pay its shareholders a dividend of 50 cents per share, an individual who owns 200 shares of that company’s stock will receive a check for $100. When a mutual fund owns stock, the fund receives the dividends and distributes them to investors, usually in the form of additional fund shares. Thus, the value of your mutual fund investment grows when the stocks owned by the fund pay dividends.

Understanding net asset value

The value of the stocks and/or bonds owned by a mutual fund is usually stated in terms of net asset value (NAV). The number of securities in a fund may range from as few as 30 to as many as 120. As the value of the securities moves up and down, the NAV (and the purchase price) of your fund changes accordingly.

Net asset value is expressed as the value of all the securities (stocks and/or bonds) in the mutual fund portfolio divided by the number of shares of the mutual fund owned by investors. The resulting net asset value per share is the price at which shares in the fund can be bought or sold. For example, if a mutual fund owned stocks with a total value of $1 billion dollars and investors owned 100 million shares of the fund, the net asset value per share would be $1 billion ÷ 100 million = $10. Thus, it would cost an investor $10 to buy a single share in the fund, and an investor who sold a share in the fund would receive $10 for it. Because the values of stocks and bonds change from day to day, the NAV of any mutual fund also fluctuates on a daily basis. As the NAV of a fund you own rises, so does the value of your shares. When you decide to sell those shares, you receive more money than you paid for them, reflecting the higher value. (Of course, the NAV of a fund may sometimes fall.) If you’re interested, you can find the current NAV of many mutual funds listed in the business pages of your daily newspaper. Notice how the paper provides the following kinds of information:

• Fund Family: This is the company that owns and manages the specific mutual funds. Some companies, like Fidelity, operate dozens of funds with various investment objectives and styles.
• Fund Name: Shown in abbreviated form, this is the name of the specific mutual fund. In this listing, “AggGrow” stands for Aggressive Growth, whereas “Bal” (a few lines down) translates to Balanced, and “Canada” names a fund that specializes in stocks of companies based in that country.
• NAV: The net asset value per share, as described earlier in this section, as of the end of the previous business day. In this sample listing, Fidelity’s Aggressive Growth fund had a NAV of $43.57 per share.
• Daily % Return: Yesterday’s change in value of NAV from the previous day. In the listing shown, the NAV of Fidelity’s Aggressive Growth fund had fallen by 0.3% from the previous day. If you’re an investor in the fund, you don’t want to see a downward trend continue indefinitely.
• Year to Date % Return: This is the change in value of NAV from the start of the calendar year (actually, from December 31 of last year). So far this year, Fidelity’s Aggressive Growth fund has, in fact, grown aggressively — 40.2% in just a little over six months. (By contrast, the Canada fund, for example, has grown about 9.4% — still respectable for one-half of a year. You can learn much more about how to judge investment performance later in this blog)

Of course, the amount of money you make by investing in a fund won’t match the Year-to-Date % Return shown in the newspaper, unless you happened to buy your shares precisely on December 31. But the Year-to-Date % Return is a useful gauge to how the fund is performing right now. The newspaper listings also include footnotes of various kinds, indicated by lowercase letters next to the fund names. Visually scan the newspaper page for an explanation of these cryptic letters. By looking up the explanations, you can learn, for example, that the small “d” next to “AggGrow” means that you can expect a “deferred sales charge” on Fidelity’s Aggressive Growth fund. This is a worthwhile piece of information if you’re considering buying shares in this fund.