Money Talks, So Should You

Q&A: How do mutual funds work?

Tracy St. John
by Tracy St. John, The Garrett Network  (@FinancialAvenue)

A mutual fund is a wide variety of securities all in one investment. You select the type of mutual fund you want based on a specific goal you may have or how long you plan to invest your money.

I love to explain mutual funds by using a pizza analogy.  

When you make a pizza, you must have ingredients for the kind of pizza you want. Once you’ve put all the ingredients together and baked the pizza, it is ready to eat. When you eat your slice, is it just the dough? Just the sauce? Does it have the main ingredient such as pepperoni? A quality pizza would fit all your expectations.

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A mutual fund is very similar. Investment or fund managers (like Fidelity or Vanguard) choose the type of mutual fund they want to create—one that buys big companies or one that buys international companies for example. Then, the mutual fund chooses the individual securities (stocks, bonds, treasuries, etc.), similar to selecting all the ingredients that will make up the pizza.

When you buy a mutual fund, you get a portion of every single security that makes up that mutual fund just like I’d hope your slice of pizza would contain every ingredient. You pay to purchase a “slice” of the fund, which is also known as a share. That share’s price remains the same for an entire day. At the end of the day, the mutual fund makes an adjustment to its price based on all the securities within the fund and how they did in the market that day to determine the price or net asset value (NAV).

The types of mutual funds available are based on your interests. You can buy a mutual fund that buys only large company stocks or one that buys only government bonds.

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A mutual fund can also combine different types of securities such as bonds, stocks and treasuries. Buying mutual funds directly through a fund manager rather than a brokerage firm will usually save you money. Make sure to look at the specific mutual fund you are interested in as most have a minimum to invest. You may buy or sell your mutual fund at any time and receive the price for your shares based on that day’s NAV.  

It is important to know the type of mutual fund you want and then begin researching the investment or fund managers that offer this type of mutual fund. Examples of fund managers would be Fidelity, T. Rowe Price, Vanguard, etc. Good places to research mutual funds would be finance.yahoo.com and Morningstar.  
 

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Tracy St. John is the founder of Financial Avenues, LLC, a Fee-Only financial planning and investment advisory firm. She obtained her Masters Degree in Family Financial Planning as well as a Certificate in Personal Financial Planning through Kansas State University.