The Basics of Equity Mutual Funds

by Alexis A. on 2011-12-097

New investor here. I wanted to use this place as a platform for boosting my investment education. It’s no secret that I’m pretty green when it comes to the world of investments, but I’m making some progress. Or at least I thought I was until I started digging into mutual funds. I thought that a mutual fund was actually another type of investment product, like a stock or a bond, but apparently I couldn’t have been farther from the truth.

The reality is that a mutual fund is nothing more than a collection of investments that are alike in scope that are managed by a fund manager. Since my main focus is on stocks, we’re going to focus on equity mutual funds since these are simply a collection of stocks.

The Basics of Equity Mutual Funds

Okay, so many of you are probably wondering why anyone would want to invest in a mutual fund and be at the mercy of the mutual fund manager instead of engaging in stock picking and investing in individual stocks that they themselves choose. But, from what I can gather, your money is actually pooled with the cash from other investors, which gives the fund manager greater buying power and influence when it comes to buying and selling investment stocks, AND mutual funds are required by law to distribute almost all of its gains every year, giving you (the investor) much more money in your pocket in terms of dividends.

Plus, mutual funds have a more expansive oversight process which protects investors from unscrupulous fund managers since most are overseen by a board of directors or trustees. You can’t get that kind of security from a typical common stock or preferred stock purchase.

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An equity mutual fund is generally classified by the size of the companies it holds stocks in. Oftentimes you see these funds referred to as High Cap Mid Cap and Small Cap funds. (Now, I finally get what those terms mean in terms of my 401(k))! High cap funds are the big boys that tend to be more stable and experience a more regular, less dynamic rate of growth. Small cap funds refer to funds that target the small publicly held businesses that tend to be more growth oriented and therefore somewhat more risky. You can also get involved with “specialty funds” that invest in the stocks of healthcare companies only or real estate. And you can invest in domestic and international equity mutual funds, which is nice for diversity’s sake.

The idea behind investing in equity mutual funds is to weigh risk against rate of return. What I mean here is that if you are the type of investor who simply can’t stand the thought of losing one penny in the stock market or if you are close to retirement, you are considered a conservative investor and should probably stay locked into investing in high cap mutual funds that provide a more stable, less volatile return on your investment. However, if you are in a position where you can ride out the inevitable ups and downs of the stock market, you might think about putting some of your money in small cap or growth oriented funds. These funds have a greater potential for loss, but also have a lot of room for growth, which equates to a huge rate of return for you. Usually investors that have twenty years or more before they need to draw on their investment earnings can do fairly well with small cap mutual funds.

One of the best benefits of investing in a mutual fund is that you, as the investor, only have to decide what your risk threshold is before you choose a mutual fund to invest in. Of course, you need to do your homework on the mutual fund manager and the past history of the fund, but you don’t have to get into the nuts and bolts of trying to pick individual stocks. A lot of 401(k)s rely heavily upon mutual funds to provide investment options for their clients. I would suggest that first time investors who have 401(k)s take a closer look at the mutual funds available through their retirement plan and shift money around a little in order to see what the impact of certain decisions are on earnings potential.

Created June 6, 2010. Updated December 9, 2011. Copyright © 2011 The Digerati Life. All Rights Reserved.

{ 6 comments… read them below or add one }

Rob Bennett June 27, 2010 at 3:47 am

I am not a fan of mutual funds, with a few rare exceptions.

If you are a sophisticated investor, I think you are best buying individual stocks. You want to have the best investments possible. You have more control over what you possess if you go with individual stocks.

The above does not apply for the 80 percent of us who are not sophisticated investors. If you do not have the time or inclination or skill to put lots of effort into learning about the market and researching individual companies, I think you should be in index funds. Buying an index fund lets you own a tiny share of all the companies. You get huge diversification at a tiny price. You don’t have to worry about distinguishing winners from losers. You can realistically expect to earn the average long-term return for the U.S. market — 6.5 percent real (but please don’t forget to adjust your stock allocation in response to changes in valuation!).

Non-Index mutual funds are a middle ground between the two. You get diversification. But you don’t get all companies, only those favored by the fund manager. The trouble here is that most fund managers are influenced by marketing considerations. They go with what brings people into the fund rather than what works for the investor. Popularity is often a contra-indicator in InvestoWorld.

The exception to the general rule is a small number of mutual funds that are run by people of high intelligence and ethics. These do exist. But don’t assume you’ve found one unless you have put a lot of work into this. I would never advice someone to invest in a mutual fund based on what she has seen in an advertisement in a magazine. The people who write those advertisements are appealing to your emotion, not your reason.


kt June 28, 2010 at 1:08 am

whenever i think of mutual funds, i think about getting fleeced by those funds with many small fees. Makes me think that they are not for me, I would rather invest most of what i get into my online business.

A. Taskit June 28, 2010 at 1:41 am

Really fully informative post. Actually equity mutual funds are a great way to take advantage of the growth the recovering stock markets are sure to have in the coming years. The recent financial correction has left the markets undervalued and growth is sure to come. Thanks for sharing with me.

Silicon Valley Blogger June 28, 2010 at 9:48 am

Thanks for your input on mutual funds. I gather you were referring to actively managed mutual funds when you said: I am not a fan of mutual funds, with a few rare exceptions.

I consider index funds a type of mutual fund, and I am a big fan of index funds, actually. It’s what constitutes my core portfolio.

I wish I had more time in the world to manage an all stock portfolio. And if I did have more time, I’d probably try to elevate myself to “sophisticated” investor status — you know, maybe even dabble in something a bit more aggressive and do it for a living….. But alas, we don’t have all that time to spend this way and so I’d have to remain a “passive” investor (passive in the sense that I follow long term strategies that don’t involve too much trading); so far it’s worked for us reasonably well.

I can see your point. I’ll be honest and say that managing and running an online business full time can surely suck all your time. Well, for many entrepreneurs, running their business full time can surely take up a LOT of time, what more those folks who have a job and run their for-profit sites on the side? I suppose putting your money to work on your online endeavors is a form of investment that can work pretty well (if you’re serious about it).

CreditShout June 28, 2010 at 2:32 pm

Thanks for all the basics. This was really informative and well explained.

Consumermiser June 28, 2010 at 4:13 pm

Alexis A.,

Thanks for sharing thoughful information in this post.


Nice feedback and thanks for the advice on index funds. My largest investment is in index funds because its diversified stock investing in many companies and is simple and cheap.

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