In an earlier post, I wrote about index funds and why most of my retirement savings are invested in index funds. Here I want to back up a bit and define all of the terms that you need to understand before you can understand index funds.
Stocks
When you think stock, think ownership. Owning a share of stock means owning a share, a fractional part, of a company. Where does this stock come from? Let’s say one or more persons found a company, Company A. Its founders are the owners and they own all of it, 100%. At some point, they might want to sell some part of it. They might decide to split the company into 1,000 shares. Let’s say they keep 510 shares for themselves and sell the remaining 490 shares. Eventually, someone who bought one of those 490 shares might sell it to you. Congratulations! You now own 1/1,000 of Company A. You might receive 1/1,000 of Company A’s profits (if there are any, and if the company’s directors decide to distribute them instead of using them to grow the company). If Company A grows, your share will be worth more. But … if Company A goes out of business, your share might become worthless.
Stocks are bought and sold by brokers who have seats on the stock exchange. If you don’t have a seat, you need to use the services of a broker to buy or sell stock.
Bonds
Bond means lending to a borrower. Let’s say Company A sells you a bond. This means, in effect, that you have lent money to Company A. Over time, as specified, Company A will pay you back, with interest. Depending on various factors, you might be able to sell the bond to someone else, maybe for more than you paid for it. As long as you own the bond, Company A is obligated to pay you what they owe you. If you sold the bond, the new owner would receive these payments. Note that what the amount they owe you is fixed. Suppose Company A becomes the biggest thing since sliced bread, huge profits, and their stock price goes up, up, and up — Company A still only owes you what they owe you, as specified in the terms of the bond, and nothing more. Your bond isn’t going to increase in value the way a share of stock might. On the other hand, if Company A goes bankrupt, there’s some chance your bond might be worth something as the company’s remaining assets are used to pay debts.
Mutual Funds
If you have lots of money ready to be invested (say, hundreds of thousands of dollars), you can put your money into a brokerage account and divvy it up among the stocks or bonds of your choice. (We’ll assume you want a “diversified portfolio”, which means buying stock in many different companies; avoiding “putting all your eggs in one basket”.) You might have to pay a commission fee on each purchase. But a fee of a few dollars on a purchase of, say, $10,000 worth of stock isn’t unreasonable.
If you have a small amount of money to invest (say, a couple thousand dollars), there’s no way you can buy stock in dozens or hundreds of companies. If you tried, the commissions might total more than the stocks. (The commission is the same, whether you buy $5 or $500,000 worth of a company’s stock.)
A mutual fund solves this problem. Imagine you are one of thousands of people who pool their money to buy a well-diversified collection of stocks and/or bonds. In total, you and your fellow investors could easily have millions of dollars to invest. That’s more than enough for efficient investing — the commission fees being very small compared to the value of the stocks purchased. You own a fractional amount of the whole, proportional to the amount of money you invested. If the stocks in your fund’s collection go up in value, your shares in the mutual fund will go up too If stock owned by the fund pays dividends, you get your share, and they can be re-invested to buy more shares in the fund.
A mutual fund usually specializes in a certain kind of investing. For example, one mutual fund may invest in health care companies. Another might invest in large companies that have been in business for a long time or have consistently paid dividends. Another might invest in companies in a certain country or region. Yet another could invest in small or mid-sized companies that seem ready to grow quickly. (There are also mutual funds that invest in bonds.) If you can think of an investment philosophy or strategy, there’s probably a mutual fund doing it.
Every mutual funds can be put into one of two categories: Actively-Managed or Passively-Managed.
Actively-Managed Mutual Funds
Actively-managed mutual funds are probably what most people think of when they think “mutual funds”. Actively-managed mutual funds are headed by managers, who along with a team of analysts and other experts, decide which stocks or bonds (or other kinds of investments) to buy with the money investors have put into the fund by buying shares in it. They also decide when to sell the fund’s investments. You might say that mutual fund managers are stock pickers. They monitor economic and market conditions, they research companies, keeping an eye on sales, profits, and other financial data and measures of financial performance. While fund managers follow a certain investment philosophy, they generally have the authority to buy and sell as they think best.
Stock Indexes
To understand passively-managed funds, you must first understand what a stock index is. Stock indexes are a simplified way of measuring what’s happening in the stock market or part of the stock market. The Dow Jones Industrial Average (DJIA), which measures the stock prices of 30 large American companies, was established in the 1890s; the Standard & Poor’s 500 (S & P 500), which is basically, but not exactly, the 500 largest American companies, began in the 1920s. There are hundreds of other indexes.
Passively-Managed Mutual Funds
Passively-managed mutual funds, also called index funds, are designed to replicate specific stock indexes. For example, an S & P 500 fund invests in the 500 stocks that make up the S & P 500 index. Simple as that. No teams of experts continually doing market research. No investment decisions made by fund managers.
Which should you invest in? That’s your decision to make. If you want to know what I do, read why I like index funds.
