Mutual Funds : What is it? How do you buy one?
What is a Mutual Fund?
The Financial Advisor was happy to see them, and even more pleased to hear that they had been following their stocks so well. He knew that following individual stocks does take time. Another concern was that investors could not invest in many different stocks because they didn’t have money to buy stocks in so many different companies.
“I have just the solution for you”, he said.
He proceeded to tell them about Mutual Funds.
A Mutual Fund is nothing more than a bucket of funds put together by a group of individuals or investors who all agree on the same strategy for their money. These individuals essentially pool their money together so that there is more money to invest. This money is then invested by a Portfolio Manager who invests their money based on what direction the investors gave him.
The Portfolio Manager can invest the money in Stocks, Bonds, Cash and even other products. But all of these products should align with the direction that the investors gave him. For example, they could ask for investments in Technology, so the goal of the Portfolio Manager is to invest in any combination of stocks, bonds and cash that would allow the investors to maximize their profits and reduce their risks.
How do you buy into a mutual fund?
Jonah understood what the Financial Adviser said, however, one part really bothered him. “How will I know that when my money gets into a pile with others we are still getting the correct amount of profit?”
“Ah!” said the Financial Manager, “in this way, the mutual funds works just like a stock sold on a stock market”
So, before you can invest into the Mutual Fund, the portfolio manager will take the current market value of all the assets and divided by the number of units in that portfolio (minus the costs). This is called the NAV (Net Asset Value).
If you want to invest $1000 in the mutual fund, you divide $1000 by the NAV of the mutual fund and you get the number of units of the fund to buy. So, it’s really no different than the way you buy a stock.
Jonah looked a bit confused and wondered how the NAV is calculated. The Financial Adviser explained to him:
Suppose the Portfolio Manager has invested in Company 1, Company 2 and Company 3. The current portfolio and share price of these companies is as follows:
|
Company in the Portfolio |
Number of Shares of the company in the Portfolio |
Current Market Price of the Shares |
Total investment in that company in the portfolio (Share price * quantity) |
|
Company 1 |
500 |
$8 |
$4000 |
|
Company 2 |
325 |
$6 |
$1950 |
|
Company 3 |
800 |
$2 |
$1800 |
|
Total Market Value of Portfolio |
|
|
$7750 |
|
|
|
|
|
|
Total Investor units of the Fund (determined by the Portfolio Manager) |
|
|
4000 |
|
NAV= Total Market Value DIVIDED by Total Units of the Fun |
|
|
$1.9375 |
So, to understand how many units of a fund you can purchase, you divide the amount to invest by the NAV. In this case, you would do $1000/$1.9375 = 516.12 units. Depending on the mutual fund, you may or may not be able to buy a fraction of a share.