In this episode of the No-Frills Money Skills Video Series, students learn what investment companies are and how mutual funds work. The video shows the difference between savings and investing and the importance of understanding risk versus reward.
No-Frills Money Skills is a video series that covers a variety of personal finance topics. The brief videos use clear, simple language and graphic elements so that students can better visualize the personal finance content being presented. In the end, they will see how important these concepts are to their everyday lives.
This lesson received the 2015 Curriculum Silver Award from the National Association of Economic Educators. Read more about this and other awards.
As you venture into adulthood, you'll encounter many new people, places, and experiences. Regardless of your career path after high school, life will hold many challenges … a basic understanding of saving and investing should not be one of them.
On today's episode of No-Frills Money Skills, you'll learn about investment companies. Before we discuss what investment companies are and how they work, let's clarify one important point; the difference between savings and investment.
Financial professionals generally refer to savings as the accumulation of money set aside for future spending. People typically keep their savings in a low-risk account such as a savings account, checking account or certificate of deposit.
The FDIC, or Federal Deposit Insurance Corporation, insures many of these types of accounts making them free from most risk. In economics, investment consists of the purchase of capital, that is, goods that can be used to produce other goods and services.
Financial professionals, however, use the term "investment" to describe an asset that is purchased with the hope that it will gain value and provide a financial return.
How much your money can potentially earn for you depends on a number of things, but the two most important concepts are risk and reward. Risk is the chance of loss, and reward is a positive incentive that makes people better off. Generally, the higher the risk of loss for an investment, the greater the potential reward, and conversely, the lower the risk of loss for an investment, the lower the potential reward.
How do you know how much risk you can tolerate? It depends on a number of factors, including the investment purpose, your age, your personality and when you need the money. How do you know where to invest? That's a great question. Information is readily available for you to do your own research, or you can hire a professional to assist you.
There are three main types of investment companies: closed-end Funds, unit investment trusts and mutual funds, but for today's episode of No-Frills Money Skills, we'll focus on mutual funds; the most commonly known investment company.
An investment company is one that collects and pools money from many investors and invests in stocks, bonds, and other assets. Mutual funds can help diversify your investment portfolio to help you maximize your earnings and minimize your risk.
A mutual fund is an open-end company that pools investor's money, then issues shares to its investors. These shares are proportionate of the fund's holdings and the income those holdings generate.
But, before I can show you how it works, I'm going to need a volunteer from the studio audience, because it's time to play … MUTUAL BENEFIT!
Welcome to Mutual Benefit, the game show where you can win long-term financial gain! Hi. Tell us who you are and where you're from.
Hi. I'm Kim from Kimswick.
Well, Kim from Kimswick, let's get started. First, let's have you spin the Wheel of Fun(ds) to determine which type of mutual fund you'll have the opportunity to construct.
Congratulations! You've landed on "conservative fund" so you'll be constructing a mutual fund consisting of blue chip stocks. You have exactly 20 seconds and $500 to start a mutual fund by buying stocks in any combination from these great stocks! Do you have any questions before we begin?
No Kris, I don't!
Okay. The clock starts when I say … Go!
Okay, Kris, I'll take $100 worth of stock in Sure Thing Corp, $100 of Top Stock, let's see, Reliable Electric, SmartMart, and, ummm ... how about Hi-Flite Airlines?
Nice work, Kim! Now, let's double those values, because on Mutual Benefit, we match those funds!
And, for being our contestant, you'll receive an additional $100 to buy stock for your personal portfolio—not part of the mutual fund.
Awesome! Alright, let's see. I'll choose another $100 of Hi-Flite Airline.
Let's add $100 of Hi-Flite to the board. Kim, are you ready?
I sure am, Kris!
Let's see how you did.
Well, Kim, your mutual fund increased by $20 overall, but, unfortunately, your Hi-Flite stock lost $10.
I wish I could have put that $100 in the mutual fund, Kris, and bought an extra $20 of each stock. That way, even though Hi-Flite Airlines would lose value, the loss would be offset by an increase in values of the other stocks, and the mutual fund's value would have increased overall. I wouldn't have lost a thing!
I think I'll sell my Hi-Flight Stock tomorrow, and buy more shares in the mutual fund.
Good idea. You can reduce your risk of loss through diversification. Diversification helps reduce risk because you are not putting all your eggs in one basket.
That sound means we're out of time. Kim from Kimswick, take good care of your mutual fund, and thanks for playing Mutual Benefit.
Here are some characteristics to consider when investigating mutual funds.
Some funds are actively managed and some are not. The term actively managed means a group of investment professionals, or managers, buy and sell securities within the fund and attempt to make it profitable.
An index fund is an example of a fund that is not actively managed.
An index fund attempts to replicate the returns of a particular index, like the S&P 500 or Dow Jones Industrial Average. An index is a group of stocks or other investment instruments used to replicate the fluctuations of a particular market. It's a mathematical construct, or weighted average based on the various prices of stocks.
For example, if a specific index mutual fund bought one each of the 30 stocks in the Dow Jones Industrial Average—one index—then the value of each share of the index fund would move up and down with the Dow Jones Industrial Average.
Historically, index funds have earned higher returns than the average actively managed fund.
There are other aspects of investing in mutual funds you'll need to consider. You'll want to know about the fees, sales charges, often known as loads, and all the operating expenses associated with the fund.
Sales charges are fees that investors pay to the mutual fund which pays broker commissions.
A front-end load is a sales fee you pay at the time of purchase.
A deferred sales load, is paid when you sell shares.
No-load funds do not charge loads, as the name implies. If you are willing to do your own research and make your own purchases, without the benefit of an adviser, you might consider no-load funds.
Historically, mutual funds have been a good way to earn income for the future—despite the costs—but like most income, you must pay taxes on it.
You would most likely be required to pay income taxes on the dividends and interest you receive and perhaps a capital gains tax if you earn a profit when you sell.
If you have purchased mutual funds in a retirement plan through your employer there are other benefits, costs, and considerations you'll need to be familiar with. For example, some employers match your contribution up to a certain dollar amount or percentage. Free money—what a great benefit!
There are often restrictions on when you are entitled to this company match—this is called "vesting." Employees are typically vested after five years of employment and are then entitled to both their own contributions, and their employer's contributions.
You'll also want to make sure you understand the tax implications of various funds and accounts. For example, certain types of bond funds have tax advantages; however, if you take an early withdrawal from a tax advantaged account, you may be forced to pay a 10% penalty for doing so. You'll also pay any applicable income tax.
The key to investing in any financial market is to get information BEFORE investing. Every mutual fund is required to provide a prospectus; a document containing important information regarding fees, investment goals, how to buy and sell shares, as well as other information.
Mutual funds can be a great way to make your money work for you. I'm Kris Bertelsen, and I'll see you next time.