Welcome to the very first lesson of Investing Bootcamp: Mutual Funds 101
The absolute first thing I want to say is to read each lesson as it hits your inbox and as you have the time. Absorb as much you can and after all six lessons (+ bonus!) have collected in your inbox, grab a coffee or juice and read them again.
You will be super surprised how much that may have seemed new to you the first time, you now completely understand. Think of investing as a puzzle, and like any puzzle you stick with, the pieces eventually fall into place. And as the Buddhists say, “When you walk in the mist, you get wet.”
Cool? Let’s get started!
About 18 months ago, I became (perhaps overly) interested in nail polish. Specifically, Essie brand polish. A bottle of Essie nail color 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 color? Diversity. Depending on what I am wearing, the season, the shoes, the ring, the event, my mood, I must have the perfect color. 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 I gather up ten like-minded individuals, and we 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 purchase equity in a company your only option was to purchase a minimum of 100 shares through a stock broker. If the company’s equity was 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 comes 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 funds in order to spread their risk (diversify) over many stocks (or any other asset) without having to buy each stock themselves. 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 have conducted 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 stocks 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 3000 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 even two or three. 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.
Whew, that was a lot. But I often feel like that when math is involved.
Watch for Lesson #2, Introduction To ETFs, in your inbox in a few days.
ps. Throughout these six+ lessons, I may introduce terms or concepts you aren’t familiar with (yet!). Please don’t worry or think too much about it, so much of this is not taught in school. I will do my best to cover as much as I can in this email series, and if you are still looking for more information, I can show you where to find it. Promise!