In previous weeks, we discussed the two main asset classes: stocks and bonds. The next step in your investing journey is to understand an easy way to gain exposure to these assets. Mutual funds allow you to invest in a variety of assets, even if you don’t have a lot of money to invest.
With mutual funds, you invest in a basket of underlying securities by buying a portion of that basket, as opposed to purchasing many individual stocks and bonds on your own. For example, say you had $1,000 you wanted to invest in American stocks. With such a small amount of money, you would barely be able to purchase any shares, and you would be excluded from investing in a large portion of the stocks available. Household names like Alphabet, Amazon and Berkshire Hathaway all trade at over $1,000 per share; in fact, the stock price for Berkshire Hathaway is around $300,000 for a single share!
In the case of a mutual fund, asset managers such as State Street, BlackRock and Vanguard purchase thousands of underlying securities using pooled money from investors. Similar to how you purchase a share of a company when you buy a stock, you buy shares of a mutual fund. However, when you invest in a mutual fund, you purchase a portion of the fund’s net asset value (NAV) — the total value of all underlying assets in the fund. Thus, you gain exposure to everything in the fund, even by purchasing just one share!
As you can see, mutual funds are a great way to achieve diversification. If you tried to invest your $1,000 in a few individual stocks, you would be extremely exposed to risks related to those specific companies. However, by gaining exposure to a basket of underlying securities, you spread your risk among many different companies.
In terms of earning a return, mutual funds share some elements of individual stocks and bonds. Just as the price appreciation of a stock leads to higher returns for stockholders, the price appreciation of underlying assets in a mutual fund leads to a higher NAV, making the holdings of investors worth more. If a mutual fund invests in bonds, they can pass on coupon payments from those bonds to investors in the form of a dividend. They can also choose to bolster the NAV of the fund by purchasing more bonds.
Because the asset managers research securities, trade them and market their fund to investors, they charge fees to investors for purchasing their funds. These fees are reflected in the expense ratio, which captures how much of the fund’s assets are used for operating expenses. In general, a lower expense ratio is preferable, as expenses reduce the overall return for investors.
Overall, investing in mutual funds is an easy way for investors to gain exposure to many assets, even without a lot of capital to begin with.