One in a Million

Over 100 million people have at least one.

Most people know what they are called but cannot describe them.

Many people don’t know what to do with them. You stare at them, they stare at you and your mind goes blank.

What are they?

Mutual Funds.

Mutual Funds have become the primary investment choice for individuals in 401K plans.

They are used by institutional investors and retail investors as an efficient way to invest retirement assets.

The amount of money invested in mutual funds is staggering yet, if I asked you to describe what type of mutual funds you own, would you be able to?

The term “Mutual Fund” is used to describe a structure. When you invest in a mutual fund you are not buying individual stocks or bonds.

You are investing in a structure that owns stocks, bonds, and other asset classes.

One way to picture a mutual fund structure is to imagine a house or apartment with lots of different rooms.

One room is filled with stocks. Another room is filled with bonds. One room has silver and gold. Another room has cash.

Or every room has stocks. The apartment next door is full of bonds.

Let’s look at a hypothetical mutual fund that houses all stocks.

The living room is used for technology stocks. The kitchen is used for stocks of companies that produce refrigerators or dishwashers.

The three bedrooms are information technology , health care and financial stocks.

The landlord decides what stocks to buy, how much to buy, and what each room will hold. The landlord is also known as the investment manager.

You as the investor want to know what is in each room.

Why do you want to know?

One reason is to avoid duplication. If you own one index fund that replicates the stocks in the Standard and Poor’s 500, you do not need two other funds that do the same thing.

Duplication is not diversification of risk. Investing in different sectors of the stock market is diversification.

When you invest in a mutual fund you are buying shares. Shares, when referring to a mutual fund, means shares of the structure and a very, very small percentage of every stock in the house.

The New York City housing market works like a mutual fund I’m sorry to say, but it is a good example.

You are not investing in tangible property when you buy an apartment in NYC.

You do not own the apartment you live in. When you buy an apartment, you own shares of a cooperative or a condominium. Yes, shares.

The cooperative, also known as a  co-op is in fact a corporation that has issued shares. Each apartment in your building has a specific number of shares assigned to it.

You do own the furniture and appliances , but you must go through the board of the corporation, “the board” , to make any material changes to the apartment.

Going through a board is similar to having guidelines in a mutual fund. Guidelines in a mutual fund are used to make sure the investment manager is buying what they say they are buying.

In 2008 as the economy entered the Great Recession, investment managers of stock portfolios abandoned ship and headed into the bond market for safety.

The problem with changing strategies and buying outside the stated guidelines, is that investors who believed they owned stocks now owned bonds. And in many cases the SAME bonds, meaning you the investor were no longer diversified.

An investment in a mutual funds means you are sharing ownership of the stocks in a  mutual fund with thousands of other people you don’t know and will never meet.

You cannot change what the investment manager decides to put in the house. But you can move to another house if you want to.

Mutual fund profiles have a section that shows the portfolio holdings. The holdings are shown as a percentage of the total market value of the fund.

These are  the broad categories of the Standard and Poor’s 500 index. Below is the allocation to the different sectors in our hypothetical mutual fund.

Information Technology      20.07%
Healthcare                           15.58%
Financials                            13.70%
Communication Services      9.87%
Consumer Discretionary       9.85%
Industrials                             9.36%
Consumer Staples                 7.41%
Energy                                   5.51%
Utilities                                  3.13%
Real Estate                            2.90%
Materials                               2.62%

Total                                        100%

The way to read the portfolio holdings is to say:

“This fund owns 20% in information technology stocks. Another 15.60% of the fund is invested in healthcare stocks and 14.00% is invested in financials. This means that 50% of the fund is invested in three sectors”.

I round up the numbers. It’s just easier to understand. The percentages will change as prices change.

The world of mutual funds and exchange traded funds offers many options.

If you do not want to have exposure to a fund that has a heavy weight to information technology, you can look for a fund that invests more heavily in utilities or consumer staples for example.

Your goal in understanding what a mutual fund owns is asset allocation. Asset allocation prevents you from taking to much risk in any one stock or sector.

For a refresher on Asset Allocation, see my article on Asset Allocation.

Wow, how original is that ?

The link below will take you to a detailed list of the sectors in the S&P 500.

https://www.bloomberg.com/research/sectorandindustry/overview/sectorlanding.asp

 

 

This website is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services by The Modest Economist LLC.