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What are mutual funds, Why would I want one, and How are they different from hed

Gabrial · 1 · 277

Gabrial

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Hello everyone,,
Suppose your friend wants to open up a new sports bar. He has a great location, he's a fantastic bartender, and there's a lot of demand in town. The only thing he doesn't have is any money to get started. So, he goes around to all of his friends and asks if they'd like to invest in his business.

He needs $100,000 to get his business up and running, so he creates 100 "shares" and sells them for $1000 each.

After he raises the money, he opens the bar and it's a great success. Now everyone in town who bought a share owns 1% of his business.

You decided to buy one. Why? Because as an owner, you get a share of the profits.

Suppose that in the first year, he makes $5,000 profit after paying for rent and salaries. That money gets divided among all of the shareholders - the "owners" of the company. Since you own one share, you get $50.

The next year, he makes $8,000 profit, and you get $80.

(One other benefit is that you get to vote on how the company is run. If >50% of the owners vote to keep the bar open until 3am, that's what it will do!)

Ten years later, you decide that you need your $1000 back. You can sell your share to someone else for whatever they want to pay for it. It was a great deal for you, because in exchange for temporarily giving this business $1000 to invest, you made money on that investment, and at the end you get to have your $1000 back.

But wait, maybe it's even better than that! After 10 years the business is so successful that somebody is willing to pay you $1500 for your share in that business. Fantastic! You just turned your $1000 into over $2000 when you add up your share of the profit you made over 10 years.

What we've just described is a simplified version of the stock market. When you buy one share in Microsoft, you're buying an ownership of something more like one mlilionth of the company. As long as you own that share, Microsoft pays you dividends (a share of the profit), and when you're done investing you can sell that share to someone else.

OK, now what about the downside of investing: what if that business doesn't do well? If they lose money and go out of business, you lose everything! Or if they just don't make much profit, their stock becomes worth less because nobody wants to pay so much for one share anymore. So it's easy for an investment to go bad.

Investing in the stock market can make you lots of money, but making poor investment decisions can cost you a lot of money. How are you going to choose what to invest in? When do you sell shares in one company and buy shares in another?

That's where a mutual fund comes in.

A mutual fund is an investment in the stock market picked by an expert stock trader who chooses what to invest in for you. More specifically, what happens is that everyone who wants to invest in a fund pools their money, then the expert invests all of that money in lots of different stocks, and the value of the fund changes based on how all of those stocks do.

Almost any mutual fund is far less risky than investing in just one company.

The safest type of mutual fund is called an index fund. It just invests in the companies in one of the major stock market indexes of the top companies, like the Dow Jones or the S&P 500. These are safe because you're not relying on one person to pick which stocks to invest in - you're just investing in the top companies in the stock market.

In general, when the stock market as a whole goes up, mutual funds go up, and when the stock market as a whole goes down, mutual funds go down. Over a long term, mutual funds are a great investment - but in the short term they can lose lots of money when the stock market is going down.

OK, now finally we can get to a hedge fund. A hedge fund is more complicated than a mutual fund. A hedge fund tries to make money whether the stock market goes up or down. The details of this are pretty complicated, but as a simple example the hedge fund will buy some shares in one company, but "short" other shares in another company, where "shorting" is essentially betting that the shares will go down - you profit if the shares do go down and lose money if they go up, the opposite of owning a share.

A hedge fund may try to earn 5% every year, no matter what the stock market does. A mutual fund might make 10 or 15% one year, but lose 10% another year.

Over the long term (20 or 30 years), an index fund will outperform most mutual funds and hedge funds. But some mutual funds and hedge funds might do better - you just don't know which ones.

Over the short term (months to years), a hedge fund can be a good way to make money no matter what happens to other funds. However, hedge funds are also risky - when they make the wrong calculations, they can lose money catastrophically.

However, there's one other crucial difference: mutual funds are generally available to anyone with as little as $100 to invest, while hedge funds are only available to rich, experienced investors, typically those with millions to invest.

A common criticism of hedge funds is that they help the rich get richer without benefitting average people.
« Last Edit: Oct 24, 2019, 11:18 AM by FutureGizmo »


 


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