Mutual Funds 101

You keep hearing about them. You know people who invest in them. If you have a 401(k) account, you might already invest in some yourself. But just what are mutual funds? What's good—and not so good—about investing in them? Here's a crash course on what they are, the different types and how to decide if they're right for you.

What is a mutual fund?
Here's the three-second definition: A mutual fund is a collection of stocks, bonds or other investment instruments. It's owned by a group of investors and managed by a professional manager.

When you buy shares of a mutual fund, your money is pooled with that of other shareholders. Your pooled dollars are then invested and managed by the fund manager.

Most mutual funds are "actively managed"—which means shareholders pay the fund manager a yearly fee to actively research, buy and sell securities for the fund's portfolio.

Different mutual funds have different goals—with varying degrees of risk and return—which means they can help you meet a wide range of personal investing goals. (You'll learn more about the common types below.)

Keep in mind that mutual funds may lose value—they are not a deposit, they are not bank guaranteed and they are not insured by the Federal Deposit Insurance Corporation (FDIC) or any other government agency.

The good news
Here are some reasons to invest in mutual funds:

• The power of pooling. Because a mutual fund pools money from a number of investors, it gives you, as an individual investor, the ability to invest in a wider range of securities than you might otherwise be able to afford
  
  
• Riches not required. Many funds let you start investing with just a few hundred dollars—some with as little as $50 to $100. With many mutual funds, this small amount gets you shares in a portfolio of dozens or more securities
  
  
• Diversity does it. A typical mutual fund has a diverse portfolio (it has holdings in several different companies), so it spreads your risk over many investments. This may reduce the impact if one on the fund's investments performs poorly
  
  
• Professional polish. Once you find a mutual fund that matches your goals, you can sit back and let the professional fund manager do the work. Professional fund managers monitor the fund's holdings and performance, using in-depth research and analysis to investigate new opportunities while pursuing the fund's goals
  
  
• Cash as cash can. As with individual stocks, your investment in most mutual funds can be sold at its present market value. (Keep in mind that present market value will fluctuate, and depending on when you sell your shares, they may be worth more or less than they originally cost you.)

The downside
No investment is perfect—or perfect for every investor. Be sure you consider these points before investing in a mutual fund:

• Someone else steers. Are you a control freak? Unlike buying individual stocks for yourself, you can't pick the individual securities bought or sold for your mutual fund—the fund manager does that. You can join the ride, but you can't steer.
  
  (On the flip side, this is great if you don't have the time or desire to do extensive research or day-to-day analysis of investments.)
  
  
• A mellower mix. Metaphorically speaking, if you like straight black coffee made from one type of bean, mutual funds may not be for you. Like a gourmet coffee blend, a mutual fund contains relatively small holdings of many different securities—so if one security has an outstanding performance, it may not make a huge overall difference to the fund's performance.
  
  (On the plus side, this diversification may help reduce the risk of damage by bad performers.)
  
  
• Taxing times. Since the fund manager, not you, makes the decisions to buy and sell securities, you can't control when taxable transactions will occur. You might have to pay taxes for capital gains or income distributed by the fund during the course of the year, even if you haven't sold shares of the fund.

Common types
Mutual funds come in a variety of types. Here are seven common categories:

• Bond funds. No, they're not named after 007. Bond funds—sometimes called fixed income funds—are pooled amounts of money invested primarily in bonds.
  
  Bonds are basically IOUs from companies or governments. By investing in bonds, the fund essentially lends money to companies and/or governments, and usually collects regular interest payments until the money is paid back.
  
  Bond funds are often good choices for people who want stable income with lower risk (keep in mind that risk levels and income distributions can vary, and bonds are subject to interest rate risk and default risk). Some bond funds invest in a variety of bonds and fixed income investments; some specialize in conservative, investment-grade corporate bonds; and some specialize in high-risk junk bonds.
  
  
• Stock funds. You guessed it—stock funds are pooled amounts of money invested primarily in stocks.
  
  Sometimes called equity funds, stock funds are often good choices for investors with a long-term investment horizon (those who plan to invest for five years or more) and who are looking for growth of capital.
  
  Stock funds come in many types, varying in investment style and company size. For example, depending on your goals, you might invest in an aggressive small-cap growth fund (which would have more market volatility than a fund made up of securities or larger, well-established companies, and carries special kinds of risks) or a conservative large-cap income fund, which has different risks.
  
  
• Balanced funds. Balanced funds mix some stocks with some bonds. For example, a balanced fund might contain 50 to 65 percent stocks, with the rest of the money invested in bonds.
  
  Balanced funds are often good choices for investors with a longer-term investment horizon (those who plan to invest for five years or more) who are looking for a mix of growth capital and current income.
  
  Compared to stock funds, bond funds can be fairly conservative. But be sure you know the distribution of stocks to bonds in a balanced fund before you invest—so you fully understand the fund's potential for risks and rewards.
  
  
• Money market funds. Money market funds are pooled amounts of money that invest in high-quality, short-term money market securities (which generally mature in one year or less—sometimes in as little as 30 days or less), such as treasury bills and commercial paper.
  
  These funds seek to preserve the value of your investment at one dollar per share (with fluctuating interest rates), though it's possible to lose money by investing in them. But because they make short-term investments in large, creditworthy banks and corporations, they're considered the lowest-risk type of mutual funds. However, they also tend to have the lowest returns.
  
  Investments in money market funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other governmental agency.
  
  Money market funds often offer check-writing privileges. Be sure to pay close attention to fees when choosing a money market fund.
  
  
• Index funds. Index funds invest money in the stocks of a market index (a benchmark that represents market returns, such as the S&P 500), with the goal of getting the same overall returns as the market.
  
  A true index fund adjusts its portfolio often to closely mirror an index. Index funds tend to be "passively managed"—which means portfolio adjustments are automated, based on the index—so fees tend to be lower than those of actively managed funds.
  
  
• International and global funds. International funds invest in companies outside of the United States. Global funds invest in both U.S. and international companies. Both types tend to be more volatile than domestic funds, as they're subject to currency, political and economic risks.
  
  
• Sector funds. Sector funds invest in one particular sector of the economy, such as technology, healthcare, financial services, computers, natural resources, utilities, precious metals or real estate. Because they aren't diversified across industries, these funds can be extremely volatile. The name of the fund often tells you what the fund's focus is.

Which one is for you?
Now that you know what types of mutual funds are out there, how do you decide which specific fund (or funds) are right for you? These steps should put you on the right path:

1. Write down your financial goals and investment time horizon. Why? If you want to meet a long-term goal—such as saving for a distant retirement or a baby's college education—you need a different strategy than you do to meet a short-term goal such as buying a new house or going on a vacation.
   
   
2. Know your tolerance for risk—and match it to the fund's risk. Now that you know the general risks involved in different types of mutual funds, find one that matches your tolerance.
   
   
3. Narrow down the results. Now that you know your goals, your time horizon, your tolerance for risk and the types of mutual funds out there, it's time to sit down with an investment professional to get help picking specific funds to match your goals.

A final note: Read the prospectus
Be sure to read a mutual fund's prospectus carefully before you invest in it. The prospectus will give you important information on the fund's:

• Investment objectives and policies
• Investment strategy
• Risk
• Past performance
• Charges and expenses

You can get a prospectus from an investment professional or directly from the fund company. Your investment professional can answer questions and explain any points in the prospectus that you don't understand.

To schedule a free consultation, find an investment professional at a WaMu financial center near you.