Mutual Funds For Dummies. Eric Tyson
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Differences in investment objectives are how funds broadly categorize themselves, like the way an automaker labels a car a sedan or a sport utility vehicle. This label helps you, the buyer, have a general picture of the product even before you see the specifics. On the dealer’s lot, the salespeople take for granted that you know what sedan and sport utility vehicle mean. But what if the salesperson asks you whether you want a Pegasus or a Stegosaurus? If you don’t know what those names mean, how can you decide?
Fund terms, such as municipal bond fund or small-cap stock fund, are thrown around casually. Fact is, thanks to our spending-oriented culture, too many folks know car models better than types of funds! In this chapter (and in Chapter 2), I explain the investment and fund terms and concepts that many writers assume you already know (or perhaps that they don’t understand well enough themselves to explain to you). But don’t take the plunge into funds until you determine your overall financial needs and goals.
Making Sense of Investments
Your eyes can perceive dozens of different colors, and hundreds, if not thousands, of shades in between. In fact, you can see so many colors that you can easily forget what you discovered back in your early school days — that all colors are based on some combination of the three primary colors: red, blue, and yellow. Well, believe it or not, the world of investments is even simpler than that. The seemingly infinite number of investments out there is based on just two primary kinds of investments: lending investments and ownership investments.
Lending investments: Interest on your money
Lending is a type of investment in which the lender charges the borrower a fee (generally known as interest) until the original loan (typically known as the principal) gets paid back. Familiar lending investments include bank certificates of deposit (CDs), United States (U.S.) Treasury bills, and bonds issued by corporations, such as Chipotle.
In each case, you’re lending your money to an organization — the bank, the federal government, or a company — that pays you an agreed-upon rate of interest. You’re also promised that your principal (the original amount that you loaned) will be returned to you in full on a specific date.
The best thing that can happen with a lending investment is that you’re paid all the interest in addition to your original investment, as promised. Although getting your original investment back with the promised interest won’t make you rich, this result isn’t bad, given that the investment landscape is littered with the carcasses of failed investments that return you nothing — including lunch money loans that you never see repaid!
You may not get everything you were promised. Under extenuating circumstances, promises get broken. When a company goes bankrupt (remember Bear Stearns, Enron, Lehman, Sears, WorldCom, and so on), for example, you can lose all or part of your original investment (from purchased bonds).
You get what you were promised, but because of the ravages of inflation, your money is simply worth less than you expected it to be worth. Your money has less purchasing power than you thought it would. Suppose that you put $5,000 into an 18-year lending investment that yielded 4 percent. You planned to use it in 18 years to pay for one year of college. Although a year of college cost $5,000 when you invested the money, college costs rose 8 percent a year; so in 18 years when you needed the money, one year of college cost nearly $20,000. But your investment, yielding just 4 percent, would be worth only around $10,100 — nearly 50 percent short of the cost of college because the cost of college rose faster than did the value of your investment.
You don’t share in the success of the organization to which you lend your money. If the company doubles or triples in size and profits, the growth is good for the company and its owners. As a bondholder (lender), you’re sure to get your interest and principal back, but you don’t reap any of the rewards. If Elon Musk had approached you years ago for money for his then new company Tesla, would you rather have loaned him the money or owned a piece of his company?
Ownership investments: More potential profit (and risk)
You’re an owner when you purchase an asset, whether a building or part of a multinational corporation, that has the ability to generate earnings or profits. Real estate and stock are common ownership investments.
Through the investment’s own cash flow/income: For example, as the owner of a duplex, you receive rental income from tenants. If you own stock in a corporation, many companies elect to pay out a portion of their annual profits (in the form of a dividend).
Through appreciation in the value of the investment: When you own a piece of real estate in an economically vibrant area or you own stock in a growing company, your investment should increase in value over time. If and when you sell the investment, the difference between what you sold it for and what you paid for it is your (pre-tax) profit. (The IRS, of course, will eventually expect its share of your investment profits.) This potential for appreciation is the big advantage of being an owner versus a lender.
On the downside, ownership investments may come with extra responsibilities. If the furnace goes out or the plumbing springs a leak, you, as the property owner, are the one who must fix and pay for it while your tenant gets to kick back in their recliner watching football games and eating nachos. And you’re the one who must pay for insurance to protect yourself against risks, such as fire damage or accidents that occur on your property.
Moreover, where the potential for appreciation exists, the potential for depreciation also exists. Ownership investments can decline in value as we saw happen in the early 2000s, late 2000s, and in early 2020. Real estate markets can slump, stock markets can plummet, and individual companies can go belly up. For this reason, ownership investments tend to be riskier than lending investments.
Surveying the Major Investment Options
When you understand that fundamentally two major kinds of investments — ownership and lending — exist, you can more easily understand how a specific investment works … and whether it’s an attractive choice to help you achieve your specific goals.
Which investment vehicle you choose for a specific goal depends on where you’re going, how fast you want to get there, and what risks you’re willing to take. Here’s an inventory of investment vehicles to choose from, along with my thoughts on which vehicle would be a good choice for your situation.
Savings and money market accounts
You can find savings and money market accounts at banks; money market funds are available through mutual fund companies. All are lending investments based on short-term loans and are about the safest in terms of short-term risk to your investment among the various lending investments around. Relative to the typical long-term returns on growth-oriented investments, such as stocks, the interest rate (also known as the yield) paid on savings and money market accounts is low but doesn’t fluctuate as much over time. (The interest rate on savings and money market accounts generally fluctuates as the level of overall market interest rates changes.)
Bank savings accounts are backed by an independent agency of the federal government through Federal Deposit Insurance Corporation (FDIC) insurance. If the bank goes broke, you still get your money back (up to $250,000 per depositor, per insured bank). Money market funds, however, aren’t insured.