So you've decided to start investing.
Good for you! Investing in stocks, real estate, and other assets is a great way to turbocharge the rate of growth of your wealth.
It is also the only way to preserve the value of your money over long periods of time (greater than a few years).
For those considering investing in mutual funds, however, an understanding of what you're getting into is critical.
Mutual funds on the surface can appear almost like a savings account.
You may get a statement each month (or every few months) giving the value of your holdings.
You can also check the balances each day online.
Also, unlike buying stocks directly, you are also able to put small amounts of money into funds, just as you could into a bank account.
You can therefore send a few dollars here and there as you can.
Some funds also report both the return of the fund and your personal rate of return.
Looking at an annual report, you may see that a fund that has returned an average rate of 12% over the last five years and 19% in the last year.
While it is easy to compare these numbers with that of a savings account or bank CD, currently at or well below 1%, and be ready to drop all of your savings into the mutual fund.
There is an important difference between the return of a mutual fund, however, and that of a bank account or CD.
When you put money in the bank, you make an agreement with the bank that they will 1) keep your money safe and 2) pay you a particular rate of return.
This means that you can accurately predict the future value of your money in both the short and long-term.
For example, if you put $100 into a CD that pays 1% interest compounded annually, you can predict with almost certainty that at the end of the year you will have $101.
The rates of returns on funds are not based on an agreement between you and the mutual fund.
They are the rates of return that the fund has achieved in the past.
It is not possible to predict the rate of return of the fund in the next few months or even the next few years.
This means that if you invest that same $100 in a mutual fund, you will have no idea how much money you will have at the end of a year.
You can probably do a good job of bounding the range - for example it is very unlikely that there would be less than $70 or more than $130, but you certainly could not guarantee that you would have $101 or even $100 in the fund.
So why would anyone invest in mutual funds? Well, even though it is very difficult to predict the rate of return, over long periods of time one can be nearly certain that the return from mutual funds will be more than inflation.
Furthermore, one can be certain that the returns from bank accounts will be less than inflation.
This means that over 20 years, your can be almost certain that money invested in a mutual fund will be worth more than you put into it.
Conversely, you can also be absolutely certain that the value of funds you put in the bank will be worth less than their initial value.
This means that money put in a bank account will slowly wasted away due to inflation, while funds in a mutual fund will not.
Why is this? When you are buying mutual funds, you are buying a large basket of stocks.
Because the parts of the companies - the land, the buildings, the equipment, the capability to make money, the logos, the patents, etc...
- will rise in cost with inflation, the stock price will also rise.
Furthermore, as the companies grow and are able to make more money, the value of the company, even after taking inflation into account, will grow.
Since around 1900, stocks have returned more than 6% after inflation.
Bank accounts have had a return of -2 to -3% after inflation.
So when buying a mutual fund, think of it as starting out a road trip in LA and heading towards Colorado (without the benefit of a map).
You know that eventually you will be at a higher altitude.
As you drive, however, there will be ups and downs.
You therefore don't want to start on the trip if you'll need to get out of the car soon because you could end up jumping out in the middle of Death Valley.
If you can stay for the duration, however, you know you will end up on a mountain peak eventually.
Good for you! Investing in stocks, real estate, and other assets is a great way to turbocharge the rate of growth of your wealth.
It is also the only way to preserve the value of your money over long periods of time (greater than a few years).
For those considering investing in mutual funds, however, an understanding of what you're getting into is critical.
Mutual funds on the surface can appear almost like a savings account.
You may get a statement each month (or every few months) giving the value of your holdings.
You can also check the balances each day online.
Also, unlike buying stocks directly, you are also able to put small amounts of money into funds, just as you could into a bank account.
You can therefore send a few dollars here and there as you can.
Some funds also report both the return of the fund and your personal rate of return.
Looking at an annual report, you may see that a fund that has returned an average rate of 12% over the last five years and 19% in the last year.
While it is easy to compare these numbers with that of a savings account or bank CD, currently at or well below 1%, and be ready to drop all of your savings into the mutual fund.
There is an important difference between the return of a mutual fund, however, and that of a bank account or CD.
When you put money in the bank, you make an agreement with the bank that they will 1) keep your money safe and 2) pay you a particular rate of return.
This means that you can accurately predict the future value of your money in both the short and long-term.
For example, if you put $100 into a CD that pays 1% interest compounded annually, you can predict with almost certainty that at the end of the year you will have $101.
The rates of returns on funds are not based on an agreement between you and the mutual fund.
They are the rates of return that the fund has achieved in the past.
It is not possible to predict the rate of return of the fund in the next few months or even the next few years.
This means that if you invest that same $100 in a mutual fund, you will have no idea how much money you will have at the end of a year.
You can probably do a good job of bounding the range - for example it is very unlikely that there would be less than $70 or more than $130, but you certainly could not guarantee that you would have $101 or even $100 in the fund.
So why would anyone invest in mutual funds? Well, even though it is very difficult to predict the rate of return, over long periods of time one can be nearly certain that the return from mutual funds will be more than inflation.
Furthermore, one can be certain that the returns from bank accounts will be less than inflation.
This means that over 20 years, your can be almost certain that money invested in a mutual fund will be worth more than you put into it.
Conversely, you can also be absolutely certain that the value of funds you put in the bank will be worth less than their initial value.
This means that money put in a bank account will slowly wasted away due to inflation, while funds in a mutual fund will not.
Why is this? When you are buying mutual funds, you are buying a large basket of stocks.
Because the parts of the companies - the land, the buildings, the equipment, the capability to make money, the logos, the patents, etc...
- will rise in cost with inflation, the stock price will also rise.
Furthermore, as the companies grow and are able to make more money, the value of the company, even after taking inflation into account, will grow.
Since around 1900, stocks have returned more than 6% after inflation.
Bank accounts have had a return of -2 to -3% after inflation.
So when buying a mutual fund, think of it as starting out a road trip in LA and heading towards Colorado (without the benefit of a map).
You know that eventually you will be at a higher altitude.
As you drive, however, there will be ups and downs.
You therefore don't want to start on the trip if you'll need to get out of the car soon because you could end up jumping out in the middle of Death Valley.
If you can stay for the duration, however, you know you will end up on a mountain peak eventually.