Sushi, Motorcycles, and the Basics of Mutual Funds
by Steve Diggs

As I go to churches around the country presenting the No Debt No Sweat! Christian Money Management Seminar I probably get more questions about mutual funds than any other one topic. Millions of Americans who own these investments won't understand much about them.

I've learned that when I get too technical about mutual funds, peoples' eyes glaze over. Then, they lose interest. And, when that happens, they deprive themselves of learning about what may be one of the average person's greatest investment tools.

Mutual funds aren't perfect investments. As a matter of fact, I don't know of a perfect investment. (No investment always has high returns with low risks.) But, mutual funds often do allow the small investor to enjoy many of the benefits that would otherwise only be available to the richest investors.

Although they date back to at least the 1920's, mutual funds really hit their stride in the last twenty years or so. According the Investment Company Institute, as of 2000, there were about 8200 mutual funds available to the public.

Different funds have different purposes and personalities. They invest in different types of assets. The costs, fees, and expenses of various funds vary widely -- to say nothing of their performance. Add to this mix the fact that every investor has different needs, goals, and risk tolerances. With all these factors in mind, this could become a confusing topic. But, I will try my best to keep it simple and clear.

To accomplish that goal, please understand that I will not be getting into the highly technical aspects of mutual fund investing. If you want to learn more, there are lots of great books and websites that will help you do that. For these purposes I will be making broad assumptions and sharing generalized concepts. Nothing is meant to be the final word, or exhaustive. As with everything else I share, please understand that is your responsibility to get further and more complete information before you invest. In addition to getting competent professional advice, I would encourage you never to buy any mutual fund until you understand it. While mutual funds offer many advantages, they have their trade-offs, too. Always read the prospectus carefully, ask questions, and get satisfactory answers before you invest.

Sushi and Motorcycles: The Perfect Mutual Fund Analogy

As I tried to hit on the best way to explain mutual funds, it suddenly came to me -- mutual funds are a lot like two of my favorite things; sushi and motorcycles! I love Japanese sushi and Harley Davidson Motorcycles, but they are both acquired tastes.

The first time I tried sushi it was a real learning experience. It was like going through an initiation at a bait shop! I didn't know the difference between a hand roll and a crunchy shrimp roll, and I didn't know wasabi from ginger. I soon learned that, if I planned to eat sushi, I had better learn the language. There were some basic words and terms that I needed to understand. Mutual funds are much the same. To deal with mutual funds there are some foundational terms and phrases that you will need to understand. Mutual funds also have a lot in common with motorcycles in the sense that they may all look the same to an untrained observer, but it's the differences that make them interesting --and potentially deadly.

As a Harley guy, I love to talk about my bike. It's a gorgeous, black, 1997 Road King with a fuel-injected, 1340cc Evolution engine. Now, don't confuse it with a Harley Sportster 1200 or a Heritage Softail. And, by all means, don't confuse any Harley Davidson with an Indian or a Honda! That's not to say that one is better or worse than another. It's just that they are all different. They do different things. They have different feels. They suit different people.

By the same token, mutual funds fall into a number of categories. Within these categories are sub-categories. Different funds invest in different assets. And the funds themselves are owned by numerous fund companies that have their own personalities and investment styles.

Just the Facts, Ma'am

I always liked the old Dragnet Show. Joe Friday had a way of finding the bad guy by always asking for "just the facts, ma'am." I guess when you've got to solve a caper in 30 minutes (minus commercials), staying focused is important. So, let's spend a few minutes talking about the facts of mutual fund ownership.

Today, some 95 million Americans own shares in mutual funds. These individuals hold about 80% of the money invested in mutual funds. That's up from less than 5 million in 1980. Today there is around $7 trillion dollars invested in mutual funds.

The Investment Company of America has some interesting data about the type of people who buy mutual funds, too. On balance, they are a mirror reflection of the U.S. population as a whole. The typical fund investor is age 44, married, and in the process of saving for retirement with median household assets of $80,000. The majority is willing to accept at least a moderate level of risk in exchange for moderate gain, and is not focused on the short-term ups and downs in the market.

Starting At the Beginning (Types of Mutual Funds)

Like they say, the best place to begin anything is at the beginning. So, let me start by telling you what a mutual fund is.

Essentially, a mutual fund is an investment that pools your money with the money of numerous other shareholders, and invests that money in various securities (like stocks, bonds, and money market instruments) in the hope of achieving a specified goal. Each investor (or, shareholder) who owns shares in the mutual fund participates in the fund's gains or losses.

Typically, there is a fund manager (or, in some cases, a group of managers) who plans and executes the fund's investment activities in keeping with the stated aims of the fund. While there are various types of funds that hold an array of different investments, in this writing we will limit our focus to four primary types of mutual funds:

1) Stock (or, Equity) Funds are by far the most popular of the four types of funds. As of 2000, $3.96 trillion of the $6.97 trillion invested in mutual funds was in stock funds. Such funds build their portfolios by purchasing the stocks of a number of companies. When you invest in a stock mutual fund you get an indirect equity (or, ownership) holding in the companies in which the fund invests.

2) Bond Funds held $808 billion of investors' money as of 2000. A bond is essentially a debt, or an IOU, usually issued by a government, government agency, or a corporation. Bond mutual funds invest in such instruments.

People who want to live off dividend income frequently invest in bonds or bond funds because of their historical stability.

3) Money Market (or, Cash Equivalent) Funds were where investors were storing some $1.85 trillion as off 2000. These are usually intended to be liquid funds (readily accessible) that invest in shorter-term instruments (often with maturities of ninety days or less.) Money market funds are designed to offer a relatively safe harbor for people concerned about losing money in more volatile investments. But unlike what some people believe, money market funds are like other mutual funds in that they generally are not insured or guaranteed by the FDIC or any other governmental agency. Such funds may seek to maintain a $1.00 per share price, but it is possible to lose money even in these funds.

Some of the advantages of money market funds are their easy accessibility, many offer free check writing privileges (certain minimums and other conditions may apply), and often they pay higher yields than bank accounts.

4) Hybrid Funds is a smaller category of investment products that invest in a mix of stocks, bonds, and/or other items. Considered by many to be an effective way to make investing simpler, these funds can give you instant diversification across a number of investments. One category of hybrids is Balance Funds that typically invest in a blend of stocks and bonds. The goal is to smooth out the volatility that often comes with market ups and downs.

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