The thought of dealing with household finances and retirement planning is enough to make many people cringe. As if the whole experience isn't intimidating enough, you're immediately bombarded with an entire dictionary of puzzling concepts and jargon that's enough to make anyone's head spin. From Keogh Plans, Roth IRAs and 401(k) to SEPs and 403(b) tax-sheltered annuities, just keeping all the options and definitions straight is a considerable task in itself. But knowledge is a great weapon, and a great way to develop a comfort level with the wide variety of concepts is to take a look at each one and develop a basic understanding of how each works. After educating yourself on the options, you'll be able to breathe a bit easier when the buzzwords begin to fly.
For those just starting to save for retirement or making the initial steps toward starting a retirement plan, one of the most common investment options that will be presented is the mutual fund. The Securities and Exchange Commission (SEC) describes a mutual fund as "a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments." In other words, a mutual fund is comprised of many different financial elements and buying a share in the mutual fund is like buying a small part of each of those individual elements. When you hear the term "portfolio" used in conjunction with mutual funds, it is referring to the combined holdings that the mutual fund owns. When you buy a share of a mutual fund, you are buying a proportionate ownership of the fund's holdings (for example: 1/10,000th if there were 10,000 shares available) and a proportionate share of any income those holdings generate.
As with any investment option, mutual funds have their own advantages and disadvantages. On the good side, the SEC notes that:
- Mutual funds are professionally managed meaning there are a number of financial professionals researching, selecting, and monitoring the various securities purchased by the fund.
- Mutual funds are a way to achieve diversification. In other words, you "don't put all your eggs in one basket." Your investment is spread across a wide range of companies in different fields and market sectors.
- There are a variety of mutual funds and many are designed for investors who don't have a lot of money to invest. This often results in low dollar amounts for initial purchases.
- Mutual funds are liquid, meaning a mutual fund investor can redeem his or her shares at the current net asset value (NAV)—the price an investor pays for a mutual fund share.
On the downside, the SEC notes that mutual funds have disadvantages including:
- Investors must pay sales charges, annual fees, and other expenses regardless of how the fund performs.
- Since a fund's managers are constantly monitoring and changing its makeup, it is difficult for an individual investor to know the exact composition of a fund's portfolio at any given time. An individual investor also has no input into which securities the fund manager buys or sells.
- Unlike individual stocks, mutual fund share prices are typically not available in real-time. Mutual funds must generally calculate their net asset value at least once each business day, which is typically done after the daily close of the major US stock exchanges.
Now that banks and insurance companies are able to offer more financial products to their customers, you must keep in mind that investment options, such as mutual funds, are different than savings and checking account deposits. Bank deposits are typically insured against loss by the FDIC up to a certain dollar amount. Investments like mutual funds, are not deposits and are not insured and protected (like bank deposits) by the FDIC even though they may be offered through a bank. Any money you place in such a fund is subject to investment risk including the possible loss of your principal (the amount you invested).
You work hard for your money and retirement planning is a responsibility each of us must undertake. Don't be afraid to do your own research and ask questions. The only stupid question is the one that wasn't asked. With a solid base of information and financial knowledge, you'll be more comfortable and confident in making sound financial decisions to establish a secure future for yourself and your family.
Always consult with your financial advisor and tax consultant before undertaking any investment plans
Sources:
Federal Deposit Insurance Corporation—www.fdic.gov
US Securities and Exchange Commission—www.sec.gov
