Extreme Newbie Mutual Funds Question

Hi Barclay,

Thank you for asking these questions! There's no need to feel embarrassed. I think a lot of people wonder the same thing but are too afraid to ask, or don't know how to ask.

When you invest in a mutual fund you are investing in a bunch of stocks, or bonds, or both. Mutual funds are often divided into two categories: actively managed funds and passive, index funds.

Actively-managed mutual funds are run by investment managers who try to do better than the general market by buying and selling stocks and bonds at certain times. These funds usually have high fees because investors have to pay for the manager's time and expertise.

Index funds are mutual funds that track market indexes. Sound like I went in a circle? Stay with me!

Market indexes are used to measure how different pieces of the market are performing. Think of them as thermometers. We don't invest in them - instead we just read them. A stock index usually tracks a wide selection of stocks in a certain area of the market so that one stock's performance doesn't affect the index's overall reading. For example, the S&P 500 Index tracks 500 of the largest U.S. company stocks. The Russell 2000 Index tracks 2000 of the smallest U.S. company stocks. We use them to measure how U.S. large company stocks and U.S. small company stocks are faring, respectively. There are indexes that track technology stocks, international stocks, bonds, real estate, just to name a few.

Index mutual funds are constructed to perform like the market indexes I just described. For example, there are U.S. stock market index funds that track the S&P 500. These funds aren't very expensive because they don't require a lot of work. Managers aren't moving stocks (or bonds) in and out of them.

Here's the thing -- a lot of research shows that very few active managers beat the general markets over long periods time, especially when their fees are taken into consideration. For that reason, most of us are best off investing in low-cost index funds.

As for your last question: index mutual funds are offered by mutual fund companies like Vanguard and Fidelity. These funds usually require you to invest a minimum amount and charge a manager fee. You can read about some of the different mutual fund companies here.

You need a broker to help you buy and sell individual stocks. Broker's fees vary depending on who you use. They often charge you for each transaction. Read about some here. But remember, few well-trained investment managers can beat the general markets over long periods of time. Can you?

Sorry for the lengthy response. Please let me know if any of my explanation isn't clear.