Mutual Funds 101
About 18 months ago, I became (perhaps overly) interested in nail polish. Specifically, Essie brand polish. A bottle of Essie nail colour is $10.00. Let say (hypothetically in case my husband is reading this), that I have amassed 50 bottles of Essie polish. This number puts my total investment (although even I would not claim nail polish is an asset) at $500.
Why do I need 50 bottles of colour? Diversity. Depending on what I am wearing, the season, the shoes, the ring, the event, my mood, I must have the perfect colour. This desire may be excessive, but we will leave that debate for another day. Suffice to say, that in nail polish and investing, more is better than one.
Can anyone think of any other way that I might have access to 50 bottles of Essie polish without spending the entire $500 myself?
Yes! Bonus points to those of you that had the idea to gather up ten like-minded individuals and pool our funds together to purchase a shared collection of Essie products. A $50 contribution to the pot gets each of us 10% ownership in an Essie polish collection.
And this loves, would be a mutual fund.
How does this look in the real world?
For decades, if you wanted to own equity in a company your only option was to purchase a minimum of 100 shares through a stockbroker. If the firm’s equity were trading at $45.00 per share, it would cost you:
100 x $45 = $4,500 + $350 commission = $4,850
Meaning, if you wanted to have a diversified portfolio of many stocks, it would have easily cost you more than $100,000, and with broker commissions to buy and sell would have been prohibitively expensive. These up-front and ongoing costs virtually put investing out of reach for anyone except the ultra-wealthy.
But wait—along came the mutual fund!
Similar to my group of like-minded individuals who want access to a diverse collection of Essie polishes, a mutual fund is a group of investors who pool their money. They take this decision to spread their risk (diversify) over many stocks (or any other asset).
If you have $10,000 to invest, purchasing the units of a mutual fund gives you proportional ownership of the fund, equal to the amount invested. (i.e. if you invest $10,000, and I invest $5,000 – you own twice as much of the fund as I do.)
Let’s look at an example:
Jane Smith is a portfolio manager at XYZ Mutual Fund Company. Her job is to purchase the stocks of 200 companies for a new fund they are launching: the XYZ Canadian Stock Mutual Fund. After Jane and her team conduct all their research on great opportunities in Canadian stocks, the math of the fund might look something like this:
- Total value of the fund (which includes various amounts of the shares of 200 companies): $18,000,000
- Total number of units available for sale to the public (that’s you!): 2,000,000
- Value of each unit for sale: $9.00 (18,000,000/2,000,000)
If you were to purchase $27,000 of the mutual fund, you would own 3,000 units ($27,000/ $9.00). Owning 3000 of the 20,000,000 units would mean your proportional ownership of the XYZ Canadian Stock Mutual Fund is 0.15%.
If, in 2016, the value of the mutual fund increased from $18,000,000 to $20,300,000, you would be entitled to 0.15% of the gain, or $3,450 ($2,300,000 x .00015). Earning $3,450 on your $27,000 investment is a return of 12.7% ($3,450/$27,000), which is the same return the fund earned as a whole ($2,300,000/$18,000,000 = 12.7%).
The key is diversification. In the mutual fund, your risk is spread over 200 stocks. Had you purchased the individual stocks in your account, you would be lucky to afford the shares of even just two or three companies. As they say, you never want to have all of your eggs in one basket. Investing in a mutual fund provides access to the diversification you want.
That said, in the next lesson, I am going to show you a much better option (than mutual funds) to achieve diversification. Stay tuned!
Whew, that was a lot. But I often feel like that when I have to get through a wall of math.
Watch for Lesson #3, Introduction To ETFs, in your inbox in a few days.
The Fine Print:
Investing Bootcamp is provided as an educational resource and should not be construed as individualized investment advice, nor as a recommendation to buy or sell specific securities. The investments and scenarios discussed in the course are examples only and may not be appropriate for your individual circumstances.
The investing strategies presented in Investing Bootcamp will result in losses during any period of decline in the broad stock and bond markets. All investments carry the risk of loss. It is the responsibility of individuals to do their own due diligence before investing in any index fund or ETF mentioned in this course.