Mutual Funds Explained, The “Bag Analogy”
Mutual Funds despite their wide use in 401k plans and by individual investors are still often misunderstood. In this article, I hope to help you gain a greater understanding of these investment vehicles.
The “Bag Analogy”
I find analogies work well when trying to explain concepts. I like using what I call the “Bag Analogy”. Everyone understands what a bag is. It can be brown bag from the grocery store, it can be a plastic bag, or it can be a duffel bag. What is a bag’s purpose? To hold “stuff”.
What is a mutual fund’s purpose? To hold “stuff” (securities such as stocks and bonds).
If I told you had a brown bag, would you know what I had inside? Could it be eggs? Golf Balls? Trash? You really don’t know. Similarly, if someone says I have a mutual fund. Do you know what it invests in? Do you know if it’s diversified? What is its purpose?
A mutual fund can hold stocks, bonds, CD’s, other mutual funds, and other instruments.
It’s what is inside that count!
Similar to most bags, the value is what is inside. Some mutual funds invest in stocks, some in bonds, and some in more complex strategies. It important to understand what you are buying.
How are Mutual Funds Priced?
Open end mutual funds total up the value of all the investments owned (the “stuff” in the bag) at the end of the day and then divide by the number of shares to come up a fair value of the price of the shares (The finance jargon for it is “net asset value”). Let go back to the paper bag example. Image you and 5 friends send someone to the grocery store to get groceries for dinner. When they get back you have a bag full of groceries. You then look at the value of the groceries (total asset value) and divide by the number of people (5 shares) and arrive at a fair price (net asset value).
The Take Away?
Understand that mutual funds are just a legal structure or “bag” that holds the investments. The structure give you access to different investment strategies but for this article, I just want you to focus and understand that a mutual fund is mostly a structure and we look inside when making decisions about it.
Exchange Trade Funds (ETF s)- Check out our other Article
Check out my article other article that covers a similar investment vehicle here: ETF s – Exchange Traded Funds – It’s What’s Inside that Count!
Other Good Sources of information about mutual funds:
https://en.wikipedia.org/wiki/Mutual_fund
http://finance.yahoo.com/funds/
** The information on this website is intended only for informational purposes. Investors should not act upon any of the information here. Reh Wealth Advisor clients should discuss with their advisor if any action is appropriate.
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